Forex Is a Game

                                               Preface

You can’t afford to ignore forex anymore.

This is an urgent message I carry everywhere I go. It really doesn’t matter who we are or what stage in life we’re at. You could be in school and you can’t seem to figure out the rules of global finance. You could be holding down a job but you desire to make a decent second income in your spare time.

You could already be involved in the financial markets as a retail trader or investor, but with low yields and depressed growth all around the world, you are searching for an asset class that offers unparalleled returns. You might even be a fund manager who holds an international portfolio in different asset classes, such as equities, bonds, and commodities.

However, with central banks lowering rates and injecting record amounts of liquidity into the financial system, you realize the importance of protecting your entire portfolio against currency risks.

Finally, you might be someone running a multinational company. You could be based in one country, but your offices span across many countries all around the world. Expenses for salaries, infrastructure, machinery, and supplies are paid out in different currencies every single month. As the business gets larger, you can’t turn a blind eye to the currency fluctuations, which have a significant impact to the company’s bottom line every month.

If you find yourself in any one of these categories, this book is for you. The sooner we all understand the forex “game,” the better it is going to be for us. Forex is a game for three reasons. First, playing it must be fun. Second, we play it with an intention to win. Finally, it has rules. If you break the rules, the rules will break you.

HOW IT ALL BEGAN

I had a painful start to forex trading because I broke a cardinal rule. Allow me to share my story with you. I’ll be the first to admit that I’m not a smart guy. I don’t have a finance degree or an economics degree.

I studied chemical engineering in school but graduated with third-class honors, dashing my mother’s hopes of my becoming a top chief executive for a Fortune 500 company. After graduation, I proceeded to apply for a job at petroleum giant Shell, but I haven’t heard from them yet.

Sometimes I console myself by thinking that my resume lost its way in the mail. I didn’t have much materially then, but what I had was the burning desire to achieve success in life. It was this desire to succeed that led me to my first experience with forex trading.

Six years ago, I was with a friend in a local coffee shop when he suddenly flipped open his laptop to reveal a screen full of charts. Through the charts and jumping numbers on the screen, I asked him, “What’s this?”

He coolly replied, “Forex trading.”

Thinking it was some hobby he recently picked up, I asked again, “Real cash?”

“Yes.” He nodded smugly. “Real cash.”

That began to draw me in, slowly but surely. Looking back, it wasn’t the fact that forex was the biggest financial market in the world that drew me in. What drew me in was the fact that all you needed was an Internet connection and a laptop to make money from this market anywhere in the world.

Fascinated, I started to ask my trader friend some questions. When he shared with me the story of how George Soros broke the Bank of England on September 16, 1992, and made $1 billion in a day, I was hooked.

I’m the kind of guy who only needs one live example of someone who has done something to convince me that I can do it too. Excited about this new discovery called forex trading, I went off and started to do my own reading on free websites.

Soon I started my first account with USD3,000.

MY FIRST TRADE

My first trade was on the GBP/USD. It was on an uptrend, and the price had reached a new high. This is it, I thought, rubbing my hands gleefully. I’m going to be a millionaire by next Friday. Seeing that the price had reached a new high, I was convinced that gravity would pull it right down.

I clicked “sell.” That poignant moment was the start of my painful lesson. After I clicked “sell,” the price continued to creep up. That’s not supposed to happen, I thought.

As prices continued climbing, I decided to hit the sell button again, only this time with double the lot size (and double the intensity) as my first trade. I reasoned that if I clicked twice the number of lots, all that needed to happen was for prices to fall a little before I could see some nice profits.

After the second “sell” click, I couldn’t believe my eyes. The price went up further. My hands started to get sweaty. My head started to shine from the beads of sweat that started to trickle down from my bald head. Murphy’s Law was in full motion. In desperation, I actually grabbed the laptop and turned it upside down to paint me a picture of falling prices. My ego was badly hurt.

“It’s got to come down,” I muttered to myself. At that point, I clicked “sell” for a third time, with double the lot size of the second trade.

The numbers on my laptop screen at the time weren’t very far from the numbers my friend had shown me. The only difference was that mine had a stubborn negative sign preceding them that just wouldn’t go away. A couple of days after my third dreaded click, the broker closed off all my positions. I was hit with the dreaded margin call.

In a grand total of just six days, I had lost my entire account.

Whenever I share my story in my forex seminars, I replicate the scenario and draw an uptrend on the whiteboard.

“Would you click ‘buy’ or ‘sell’ over here?” I always ask, as I circle the highest point reached by the price. At every single seminar, most people choose to sell, confident that high prices will fall.

It’s almost a consolation to know that we human beings are wired in much the same way. Needless to say, after I blew up my account, I was devastated.

THERE ARE NO SUCCESSFUL BUSINESSES

Losing USD3,000 of my hard-earned money in a week was heart-wrenching.

Self-defeating thoughts appeared in my mind incessantly.

“Forex is risky.”

“Forex is gambling.”

“Forex is not for me.”

I was tempted to wash my hands from the forex market and walk away.

However, it was at this low point of my life that the words of a rich and successful Chinese businessman who was my mentor came to mind.

“There are no successful businesses in this world, only successful people.”

At this point, I stopped the pity party and asked myself two questions: Do I know people who are making money in the forex market? And: Do I want to be in that group?

I picked myself up again after I answered yes to both questions. I started to work on myself. You see, it’s very easy for you and me to get sucked into recognizing that 80% of people lose money in the forex market.

However, why can’t we decide to be in the group that makes money? Isn’t it just a simple switch in our thinking? If 20% of the people are making money, let’s decide first to have our names in that special group. That self-talk was the turning point in my forex trading journey. I made up my mind to master forex trading.

Picking myself up from the setback, I began to equip myself with the right trading skills. I started devouring books by successful traders. Emulating their beliefs, knowledge, and habits, I worked hard on honing my trading skills every single day. My quest for mastery also led me to seek out two of the biggest names in the forex industry as my mentors: Kathy Lien and Ed Ponsi.

I reasoned that a mentor could help me to drastically cut short my learning curve. And cut short my learning curve they did.

Knowing what I know now, I recognize that the cardinal rule that I broke in my first live trading experience was to trade against the trend.

Within three years and several buckets of blood, sweat and tears later, I became an expert in trading the forex market. Less than a year later, I was invited to appear on CNBC to give my opinions on global finance.

WISH THAT YOU WERE BETTER

Given my bubbly character, many people think that it’s easy being on camera, speaking live to a camera that holds the attention of over 300 million viewers. The truth for me is that it’s not.

“Mario, what do you think the CPI is going to be for Singapore?”

“Mario, what’s your view on the U.S. dollar this week?”

“Mario, do you think China will report a good number for trade surplus this month?”

The TV anchor and the reporters on site fire questions from every angle, and you need to have the answers at your fingertips. They expect you to know, or you have no business being on the biggest stage in international finance.

How ridiculous it would be if I were to fake an answer like “I think inflation in Singapore is going to hit 65% next year.” I would be laughed off the chair.

So I had to study. In fact, to be in that three-minute hot seat, I had to study for three hours. That’s right: three full hours of study for three minutes on CNBC.

Thankfully, I did well. In fact, I did so well that I was called back, again and again. CNBC has three major shows that cover the financial markets. The early morning segment is called Squawk Box, in the early afternoon it’s called Capital Connection, and the evening’s slot is called Worldwide Exchange.

Eventually I was invited to appear on all three major shows. In fact, I was then asked to be a guest host on Worldwide Exchange. As guest host, I sat with the news anchor and instead of being there for three minutes, I would be there for a full hour.

My job was to have a conversation with some of the most brilliant financial minds on the planet who would come in and take their place on the hot seat. As I warmed up to the new role as a guest host, I had an important revelation. The job was getting easier. In fact, I didn’t have to study when I was guest host.

Do you know why? Because this time, it was my turn to ask the all-important question, “So, Jack, what’s your view on the U.S. dollar this week?”

This was my revelation: As you get better, it gets easier.

So, my friend, don’t wish that it were easier, wish that you were better.

Kaizen is the Japanese word for improvement. When we embrace kaizen in any endeavor, mastery is bound to be the result.

My kaizen approach to forex trading has enabled me to be a consistently profitable trader. Today, I am living the dream of traveling and spreading the message of profitable forex trading everywhere I go. I’ve even had the privilege to coach forex traders in some of the largest banks in the world. Forex trading has given me this new life, and I know that it can do the same for you.

AUDIENCE

Today the Forex Market is considered the largest financial market in the world. With that famous tagline, thousands of books have sprung up giving people insights into this amazing market. I did not write this book with the intention of adding to the vast list of global resources already available on the topic of forex.

My inspiration for this book is drawn from three specific groups of people:

1. All forex traders around the world. It is my humble wish that this book will become the platinum standard in forex education. The rich content here will suit you regardless of which stage you are in your trading career: beginner, intermediate, or advanced. Pay particular attention to Chapter 5, which puts you through a fun and interesting quiz. At the end of the quiz, you will discover which one of the five categories of traders you belong to. If you stick to the strategies pertinent to your profile, you will be pleasantly surprised by the results.

2. Finance and business professionals who are not currently involved in the forex market. You may be involved in equities, fixed-income instruments, or commodities. An understanding of global finance and forex movements will greatly help you in your decision making. Remember, capital flows into a country first, before it flows into any specific asset class. An understanding of the forex market puts you in prime position to anticipate these flows. Chapter 3 is dedicated to business corporations that must understand the importance of hedging. Hedging helps corporations gain certainty of price, even when payments are made or received in different currencies. Hedging thus helps corporations to mitigate the foreign exchange risk exposure.

3. Ordinary folks outside of the finance industry who are looking to create a powerful second income. With a potent combination of unprecedented liquidity and sovereign debt levels in the world today, there truly has never been a better time to get involved in forex. I ask you humbly to consider this opportunity.

OVERVIEW OF THE CONTENTS

The book is broken into two parts:

Part One: Forex Is a Game

Part One of this book is divided into five chapters, and it centers on the core description of forex as a game. We discover insights on the rules of the game, the major players, and how money is made.

Chapter 1 introduces the forex market. It begins by describing the total daily turnover and the seven major currency pairs. It then explains how to read a forex quote and how prices move. The chapter ends with a framework of how margin and leverage are employed in a forex trade.

Chapter 2 focuses on how money is made in a forex trade. We learn about long and short and the three points in every trade. We then move to the four big reasons that cause currencies to move and get a grasp of the fraction theory. Chapter 2 ends with an understanding of market structure.

Chapters 3 and 4 cover the six major players in the forex market and the numerous advantages associated with trading the market. Some of the major players include central banks, commercial banks, multinational companies, and retail traders. We also get a glimpse of three of the biggest blow-ups in proprietary trading in banking history.

Chapter 5 is devoted to discovering your unique profile in trading. It includes a profiling test to help you find out how your personality can help or hurt your trading style. There are essentially five types of traders: scalper, day trader, swing trader, position trader, and mechanical trader. By the end of this chapter, you will know which group you belong to.

Part Two: Strategies to Win the Game

Part Two is also divided into five chapters. Each chapter covers strategies for the five profiles of scalper, day trader, swing trader, position trader, and mechanical trader.

Chapter 6 covers two strategies for scalpers, called the rapid fire and the piranha. These strategies are used on the shortest time frames, namely the minute chart and the 5-minute chart.

Chapter 7 covers four strategies for day traders. The first two strategies are focused on breakouts while the next two are centered purely on trading the news. A unique way of trading the news, called the Rule of 20, is also discussed here. All four strategies are employed using the 15-minute and 30-minute time frame.

Chapter 8 covers five strategies for swing traders. As swing traders typically exit their positions within two to five days, the time frames used for the strategies are longer than the day traders. Hence, all five of the swing trading strategies are used on the 1-hour and the 4-hour time frame.

Chapter 9 covers three strategies for position traders. The first one, swap and fly, takes advantage of the interest rate differentials between the currencies and aims to earn maximum returns by holding on to positions for an extended period of time. The next two strategies are used specifically for the two most popular commodities in the world: oil and gold.

The final chapter covers three strategies for mechanical traders. Traders in this category are oblivious to the passing of time. This is why all strategies discussed here employ three different time frames from the other categories: the 5-minute chart, the 15-minute chart, and the daily chart.

art One

Forex Is a Game

Chapter 1 introduces the forex market. It begins by describing the total daily turnover and the seven major currency pairs. It then explains how to read a forex quote and how prices move. The chapter ends with a framework of how margin and leverage are employed in a forex trade.

Chapter 2 focuses on how money is made in a forex trade. We learn about long and short and the three points in every trade. We then move to the four big reasons that cause currencies to move and get a grasp of the fraction theory. Chapter 2 ends with an understanding of market structure.

Chapters 3 and 4 cover the six major players in the forex market and the numerous advantages associated with trading the market. Some of the major players include central banks, commercial banks, multinational companies, and retail traders. We also get a glimpse of three of the biggest blow-ups in proprietary trading in banking history.

Chapter 5 is devoted to discovering your unique profile in trading. It includes a profiling test to help you find out how your personality can help or hurt your trading style. There are essentially five types of traders: scalper, day trader, swing trader, position trader, and mechanical trader. By the end of this chapter, you will know which group you belong to

Reading a Forex QuoteForex prices are quoted in currency pairs and almost always to four decimal places. For example, if a forex quote is given as EUR/USD = 1.3255, the currency on the left is termed the “base currency” while the currency on the right is termed the “counter currency.” The base currency always has a value of 1. In the example, the euro is the base currency while the U.S. dollar is the counter currency. This is how we would read the forex quote: 1 euro is equivalent to 1.3255 U.S. dollars at that point of time.

Chapter 1

How to Play the Game

This chapter presents some of the essentials that you must know when you start trading the forex market. In it we describe the seven major currency pairs that are most commonly traded worldwide and explain how prices move. We also discuss the yen factor, which quotes forex prices in two decimal places as opposed to the normal four. The final part of the chapter defines the value of a pip and explains how margin and leverage affect trades.

THE FOREX GAME

The forex game has changed much over the years. Today, it is undisputedly the largest financial market in the world, with a daily trading volume in excess of USD4 trillion. The authoritative source on global forex market activity is the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, published by the Bank for International Settlements (BIS).

Available official figures for daily forex turnover are taken from the last survey done in April 2010. Fifty-three central banks and monetary authorities participated in the survey, collecting information from 1,309 market participants.

An excerpt from the BIS report reads:

The 2010 triennial survey shows another significant increase in global foreign exchange market activity since the last survey in 2007, following the unprecedented rise in activity between 2004 and 2007. Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007. This increase brought average daily turnover to USD4.0 trillion (from USD3.3 trillion) at current exchange rates.

http://www.bis.org/publ/rpfx10.htm

At the heart of the report, an interesting fact stood out. Apparently, 48% of the growth was in spot transactions, which represented 37% of the total turnover of forex transactions worldwide. Spot transactions are mostly traded by retail traders—that’s everyday people like you and me. This group is rapidly expanding and is expected to contribute an even larger portion of total forex turnover by the time the next survey is out.

This Triennial Survey is done once every three years, and the next one is due in April 2013. Publication of preliminary results will follow four months later. The official figure for daily forex turnover is expected to be well over USD4 trillion at that time. Figure 1.1 shows the breakdown of the daily turnover by instrument.

FIGURE 1.1 Breakdown of the Average Daily Turnover by Instrument (US$ billion)

Source: Bank for International Settlements, September 2010

The USD4 trillion daily turnover on the forex market is truly staggering. According to the April 2010 BIS Triennial Survey, this figure is:

• More than 23 times the average daily turnover of global equity markets
• More than 40 times the annual turnover of world gross domestic product

In fact, in the latest BIS Quarterly Review, dated March 2012, Morten Bech, senior economist in the Monetary and Economics Department of BIS, estimated that “global FX activity was around $4.7 trillion a day on average in October 2011, compared with $4.0 trillion reported by the latest triennial central bank survey of foreign exchange activity conducted in April 2010.”

Imagine that: USD4.7 trillion in a day on average in October 2011!

It certainly won’t be surprising to see the figure top the USD5 trillion mark when the official figures are released from the April 2013 survey. The good news for the retail trader is this: As a result of increasing demand, transaction costs such as spreads have decreased, technology offerings have improved, and value-added services on forex brokerage firms have exploded.

There truly never has been a better time to start trading on the forex market. This exciting message is further reinforced by the record numbers of everyday folks—people like you and me—who continue to jump onboard the forex bandwagon at an accelerated pace.

FOREX AND THE SEVEN MAJORS

Foreign exchange, or forex for short, is a market where one currency is exchanged for another. This is the reason why forex is quoted in currency pairs. Each world currency is given a three-letter code as set out by the International Standards Organization (ISO) and governed by the ISO 4217.

The eight most commonly traded currencies are:

1. USD (U.S. dollar)

2. EUR (euros)

3. GBP (Great Britain pound)

4. AUD (Australian dollar)

5. JPY (Japanese yen)

6. CHF (Swiss franc)

7. CAD (Canadian dollar)

8. NZD (New Zealand dollar)

The eight most commonly traded currencies form the seven major currency pairs. These seven majors dominate the forex market in terms of traded volume. Since January 2012, it is estimated that the seven majors account for over 85% of the daily traded volume in the forex market.

These seven major currency pairs are:

1. EUR/USD: euro versus U.S. dollar

2. USD/JPY: U.S. dollar versus Japanese yen

3. GBP/USD: Great Britain pound versus U.S. dollar

4. AUD/USD: Australian dollar versus U.S. dollar

5. USD/CHF: U.S. dollar versus Swiss franc

6. USD/CAD: U.S. dollar versus Canadian dollar

7. NZD/USD: New Zealand dollar versus U.S. dollar

Figure 1.2 shows how much volume is contributed by the seven majors. It also shows that the EUR/USD currency pair contributes the highest percentage of daily traded volume, with 28%.

FIGURE 1.2 Daily Traded Volume Contributed by the Major Currency Pairs

For all of the listed seven majors, the U.S. dollar features in either the left-hand side or the right-hand side of the currency pair. This is why the U.S. dollar is the most liquid currency in the forex world.

Reading a Forex Quote

Forex prices are quoted in currency pairs and almost always to four decimal places. For example, if a forex quote is given as EUR/USD = 1.3255, the currency on the left is termed the “base currency” while the currency on the right is termed the “counter currency.” The base currency always has a value of 1. In the example, the euro is the base currency while the U.S. dollar is the counter currency. This is how we would read the forex quote: 1 euro is equivalent to 1.3255 U.S. dollars at that point of time.

This forex quote tells us two things. First, if traders are eager to purchase one unit of the base currency, they would have to pay 1.3255 U.S. dollars to buy 1 euro. If, however, traders are eager to sell one unit of the base currency, they would receive 1.3255 U.S. dollars for selling 1 euro. It is also important to note that the exchange rate always fluctuates with changing market conditions. At any time, the euro can weaken or strengthen against the U.S. dollar.

If the EUR/USD quote moves up from 1.3255 to 1.3287, the euro is strengthening against the U.S. dollar. However, if the EUR/USD quote moves down from 1.3255 to 1.3138, the euro is weakening against the U.S. dollar.

The Yen Factor

Not all forex quotes are created equal, especially when it comes to the Japanese yen. Whenever the Japanese yen is in the counter currency, the forex quote is given in two decimal places instead of four. Let’s take a look at an example.

USD/JPY = 80.55

The quote tells us that 1 U.S. dollar is equivalent to 80.55 Japanese yen at that point of time.

If the USD/JPY quote moves up from 80.55 to 80.87, the U.S. dollar is strengthening against the Japanese yen. If the USD/JPY quote moves down from 80.55 to 79.78, the U.S. dollar is weakening against the Japanese yen.

Pip

Pip stands for “price interest point.” It is the unit of measurement to express the change in value between two currencies.

Let’s say that the current AUD/USD price is 1.0235. If the price rises to 1.0236 or falls to 1.0234, this is a movement of 0.0001, or 1 pip. If the current price of USD/JPY is 81.33, and if the price rises to 81.34 or falls to 81.32, this is a movement of 0.01, or 1 pip.

One pip is thus the smallest change in value for any given forex quote, whether it’s quoted to two or four decimal places. Here are more examples:

• When the EUR/USD quote moves up from 1.3255 to 1.3287, it is a movement of 32 pips.

When the EUR/USD quote moves down from 1.3255 to 1.3138, it is a movement of 117 pips.

• When the USD/CHF quote moves up from 0.9148 to 0.9263, it is a movement of 115 pips.

When the USD/CHF quote moves down from 0.9148 to 0.9126, it is a movement of 22 pips.

• When the USD/JPY quote moves up from 80.55 to 80.87, it is a movement of 32 pips.

When the USD/JPY quote moves down from 80.55 to 79.78, it is a movement of 77 pips.

PIPETTE

Many brokers today extend forex quotes beyond the standard four and two decimal places, to five and three decimal places respectively. As an example, a broker could quote USD/CAD as 1.00583. If the USD/CAD quote rises to either 1.00584 or falls to 1.00582, the movement is termed 1 pipette.

Similarly, if USD/JPY is quoted as 81.338 and if the currency pair rises to either 81.339 or falls to 81.337, the movement is termed 1 pipette as well.

HOW DO WE CALCULATE THE VALUE OF ONE PIP?

Different currencies have different values. Hence, the value of a pip is different for each currency.

The first thing to take note of when calculating pip value is that for most forex quotes, particularly the seven majors, the U.S. dollar is either the base currency or the counter currency.

In the USD/CHF quote, the U.S. dollar is the base currency. In the AUD/USD quote, the U.S. dollar is the counter currency.

Let’s calculate the pip value for each example, starting with the U.S. dollar as the base currency (see Examples 1.1 and 1.2).

EXAMPLE 1.1: VALUE OF 1 PIP

Let’s take the current price of USD/CHF as 0.9235. The smallest movement for a pip is thus 0.0001.

The formula for calculating pip value is:

Pip value = Smallest decimal move/Current exchange rate

= 0.0001/0.9235

= 0.000108

The value of 1 pip when the USD/CHF is at 0.9235 is USD 0.000108.

To determine the pip value for Japanese yen pairs, let’s take a look at the next example.

If the current price of USD/JPY is 81.55, the smallest movement for a pip is 0.01.

The formula for calculating pip value is:

Pip value = Smallest decimal move/Current exchange rate

= 0.01/81.55

= 0.000123

The value of 1 pip when the USD/JPY is at 81.55 is USD 0.000123.

EXAMPLE 1.2: VALUE OF 1 PIP

Let’s take a look at how pip value is determined when the U.S. dollar is the counter currency.

If the AUD/USD is now 1.0237, then:

Pip value = Smallest decimal move/Current exchange rate

= 0.0001/1.0237

= 0.00009768

The value of 1 pip when the AUD/USD is at 1.0237 is AUD 0.00009768. Take note that in this case, the value of 1 pip is quoted in Australian dollars (AUD).

To find out the value of 1 pip in U.S. dollars, we simply take the current pip value and multiply it by the current exchange rate:

Pip value (in USD) = Pip value (in base currency) × Current exchange rate

= 0.00009768 × 1.0237

= 0.0001

Thus, the value of 1 pip when the AUD/USD is at 1.0237 is USD 0.0001.

Although the process may look complicated, the good news is that every single broker you trade with will calculate this value automatically for you.

LOT SIZE

Most forex brokers today provide up to four categories of lot sizes for the trader. These are:

1. Standard lot

2. Mini lot

3. Micro lot

4. Nano lot

A standard lot is defined as 100,000 units of the base currency. For an example, when you buy 1 standard lot of EUR/USD, you are purchasing 100,000 euros with U.S. dollars.

A mini lot is defined as 10,000 units of the base currency. For an example, when you buy 1 mini lot of GBP/USD, you are purchasing 10,000 pounds with U.S. dollars.

A micro lot is defined as 1,000 units of the base currency. For an example, when you buy 1 micro lot of USD/CHF, you are purchasing 1,000 U.S. dollars with Swiss francs.

A nano lot is defined as 100 units of the base currency. For an example, when you buy 1 nano lot of USD/CAD, you are purchasing 100 U.S. dollars with Canadian dollars.

The lot size decreases by a factor of 10 from standard, to mini, to micro, and finally to nano, as shown in Table 1.1.

TABLE 1.1 Four Categories of Lot Sizes

Lot Size Category	Number of Units
Standard	100,000
Mini	10,000
Micro	1,000
Nano	100

Standard Lot

If you trade standard lots, then, using the same values as Example 1.1:

Looking at the USD/JPY example with quotes to two decimal places:

Using the same values as Example 1.2:

Mini Lot

If you trade mini lots instead, the value of 1 pip will decrease by a factor of 10.

Using the same values as Example 1.1:

Looking at the USD/JPY example with quotes to two decimal places:

Using the same values as Example 1.2:

LEVERAGE

Financial success is almost always accomplished through the use of leverage. I sum up the definition of leverage in four simple words: “Doing more with less.”

In the previous section, we talked about how the value of 1 pip dramatically increases when a trader trades a standard lot or even a mini lot. In reality, not many retail traders are able to fork out $100,000 or $10,000 to trade one standard or one mini lot.

This is where the forex broker steps in. Simply put, the business model of forex brokers is to provide retail traders with leverage so that they do not need to lay out the entire sum of $100,000 to trade one standard lot.

Let’s see how this works. If the broker provides you with leverage of 100:1, instead of $100,000, all you need to do is to pay $1,000 to trade one standard lot. Sometimes the $1,000 is referred to as margin. It is also the basis of how brokers refer to our trading account as a margin account.

Margin basically allows a trader to purchase a contract without the need to provide the full value of the contract. In the example, $1,000 was the margin required for you to trade $100,000 on a leverage of 100:1.

Using a simple formula:

Margin required = Lot size/Leverage

Hence, for the example:

Similarly, if the broker provides you with leverage of 50:1, instead of $100,000, all you need to do is to lay out $2,000 to trade one standard lot. Margin percentage in this case is then 2%.

In summary, the higher the leverage provided by the broker, the less you need to pay out to trade one standard lot.

Table 1.2 summarizes the leverage and subsequent margin requirements when you trade.

TABLE 1.2 Margin and Leverage

Margin Required	Maximum Leverage
5%	20:1
3%	33:1
2%	50:1
1%	100:1
0.5%	200:1
0.2%	500:1

From the table, it would be logical for us to conclude that we should choose the highest leverage available, since that would require us to pay out the least amount of cash to trade one standard lot.

This is not true.

Risk of Excessive Leverage

Leverage is a double-edged sword. While it has the potential to magnify a trader’s gains, it certainly has the potential to magnify losses as well. In fact, the greater the leverage, the greater the risk.

Let’s take a look at an example.

Both Trader A and Trader B open an account with a broker and start trading with a capital of USD10,000. Trader A uses leverage of 100:1 while Trader B uses leverage of 10:1. Both traders then decide to sell EUR/USD because the ongoing sovereign debt crisis is putting some pressure on the euro.

Trader A’s total contract size is 100 × $10,000 = 1 million. This equals to 10 standard lots. Trader B’s total contract size is 10 × $10,000 = $100,000. This equals to 1 standard lot.

For EUR/USD, we learned that 1 pip equals USD10 for one standard lot.

If the trade goes against them by 50 pips, both traders will incur these losses:

Trader A: (10 lots) × (50 pips) × ($10/pip) = USD5,000

Trader B: (1 lot) × (50 pips) × ($10/pip) = USD500

The USD5,000 loss represents 50% of Trader A’s trading capital, but the USD500 loss represents just 5% of Trader B’s trading capital.

Take a look at Table 1.3 for the summary of two traders who trade with different leverage.

TABLE 1.3 Trading with Different Leverage (USD)

	Trader A	Trader B
Trading capital	$10,000	$10,000
Leverage used	100 times	10 times
Total value of transaction	$1 million	$100,000
50 pip loss	−$5,000	−$500
% loss of trading capital	50%	5%
% of trading capital remaining	50%	95%

In conclusion, while leverage has the potential to magnify your profits, it also has the power to amplify your losses. It cuts both ways. After the global financial crisis of 2008 to 2010, U.S. regulators moved to regulate the forex industry there. On October 18, 2010, the National Futures Association passed rules to limit the amount of leverage retail forex brokers can provide. The rules limited leverage to 50:1 on major currencies and only 20:1 on minor currencies.

SUMMARY

The forex market is the largest financial market in the world, trading in excess of USD4 trillion in a single day. Although hundreds of currencies change hands every day, most of the trading centers on seven major currency pairs. The currency pair that handles the highest volume of trade is the EUR/USD.

A forex quote is always displayed in pairs. Examples include EUR/USD, USD/JPY, and AUD/CHF. The currency on the left is called the base currency while the currency on the right is called the counter currency. Almost all currency pairs are quoted to four decimal places, except when the Japanese yen appears in the counter currency. In such cases, the forex quote is displayed in two decimal places.

A pip is the smallest price movement in a currency pair. If the EUR/USD moves up from 1.3435 to 1.3436, this movement is called 1 pip. Similarly, if the same quote moves down from 1.3435 to 1.3434, the movement is also called 1 pip. Whenever the U.S. dollar appears as a counter currency, 1 pip earns the trader USD10 for one standard lot.

Some forex brokers go one step further and quote prices to five decimal places. For such brokers, the EUR/USD quote could be seen as 1.34358. It is important for us to take note that the fifth decimal place is not called a pip but a pipette. Quotes that have the Japanese yen as the counter currency are displayed in three decimal places instead of two in these cases.

Brokers provide retail traders with leverage to trade the forex market. Without leverage, a trader would need to pay out USD100,000 to trade one standard lot of currencies. With a 100:1 leverage, a trader would need to put up only 1/100th of the entire amount, or USD1,000. This amount is called margin. Margin basically allows a trader to purchase a contract without the need to provide the full value of the contract.

The higher the leverage employed, the smaller the margin required to trade one standard lot. Some brokers even offer leverage up to 500:1. This means traders need only USD200 to control USD100,000 worth of currencies.

Leverage is a double-edged sword. Although it helps to magnify a trader’s gains, it can also amplify a trader’s losses. Hence, it is imperative that traders fully understand the pros and cons of leverage before deciding the appropriate amount of leverage to employ.