Avoiding the pitfalls in currency trading

If you're planning to dabble in foreign exchange (FX) trading, it's important to know how to limit your risks right from the get-go.

Trading currencies known as foreign exchange, forex or FX is widely viewed as an exceptionally high-risk market. Given that most new FX traders ultimately lose money, there's evidently some truth to that.

But the risks in FX don't lie in the fact that it's an especially volatile market; big moves are relatively rare in currencies. Rather, risks arise because beginners pile on leverage to compensate for the fact that individual moves are relatively small.

This means that it's easy for them to be wiped out by a few bad trades. So if you're planning to dabble in FX, learning how to limit risks and manage leverage right from the start becomes all the more important.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The basics of forex

With that warning in mind, how does FX trading work? Currencies come in pairs: you have to take a view on one versus another, rather than just buying the currency as you would a share.

For example, you might take a view on the dollar (USD) versus sterling (GBP).Pairs are written in the form GBP/USD and the position is based on thecurrency on the left so long GBP/USD' is a bet that sterling will rise against the dollar.

Short CHF/JPY'is a bet that the Swiss franc will weaken against the yen.Currency quotes are traditionally quoted to four decimal places, except for quotes involving the yen, which run to two.

The last digit of the quote is known as a pip' or a tick' so if USD/JPY is quoted at 103.90 and it moves to 103.93, that's three pips. Some providers now provide quotes with an additional decimal place, known as a fractional pip'.

As with other forms of trading, currencies are quoted with a spread. You'll have noted this when buying currency to go on holiday the price at which you can buy is significantly higher than the price at which you can sell your leftover holiday cash.

Fortunately, spreads for FX trade are not quite as wide as they are at a currency exchange desk: at the time of writing, our broker was quoting GBP/USD at 1.65832 1.65849 (note the fractional pip in this example the fifth decimal point in the quote). Pairs involving the US dollar usually have the smallest spreads, since the US dollar is the world's most liquid currency.

Placing a trade

There are three main ways in which you place an FX trade, depending on which provider you use (some firms will offer all three). You can spread bet FX by placing a trade in terms of pounds per point (where one pip equals one point). So we might go long GBP at £10 per point based on the quote above (1.65849). If GBP falls to 1.65000, we'd lose just under £850 on this trade.

You can also use a currency CFD (contract for difference), which will usually be expressed in terms of individual contracts, each worth a fixed amount (for example one contract of £100,000), but will otherwise work much like a spread bet.

Alternatively, you can trade in terms of lots. Say we decide to trade a standard lot' of 100,000. In our example above, this corresponds to buying £100,000 and selling an equivalent amount of dollars ($165,849). Then GBP/USD falls to 1.65. At this point, our £100,000 is worth just $165,000 and we will need an additional $849 (£515) to buy back enough dollars to close our position, so that's our loss on the trade.

FX trades are often opened and closed within a day, but can also be rolled over. Each night your account will be debited or credited to reflect the interest rate differential between the two currencies in your trade.

If you have bought a higher-yielding currency versus a lower-yielding one, you will receive interest, while if you are long a lower-yielding currency versus a higher-yielding one, you will be charged interest. Some providers also offer forward contracts, which are used to bet on the price of the currency three months or more ahead. These can offer a cheaper way to take longer-term positions.

Why trade FX

Many traders are attracted to FX because of the relatively high leverage available. Some providers offer leverage of up to 500:1, meaning that small moves could theoretically make you a lot of money. But don't be under any illusions about how risky this is: if you run your account with overall leverage as high as this, you will lose the lot sooner rather than later. Leverage of 10:1 or 20:1 will be quite enough for most traders.

There are much better reasons to consider FX trading.One reason is that it offers a very large, liquid andcontinuous market. Currency trading takes place 24 hours a day although the best liquidity will be concentrated at specific points in the day when Asian trading hours overlap with European ones and European hours with US ones.

Another reason is that costs are fairly low.With most brokers, the only cost of trading is the spread, which should be relatively tight for major currency pairs. This reduces the friction caused by high trading charges, which can make high-turnover strategies inefficient in other types of investments.

Lastly, long-term trends in the FX market are driven primarily by economic fundamentals. This can make it attractivefor macro-focused traders who want to take a view onbig-picture questions, such as growth, inflation and interest rates, without having to think about company or industry-specific issues.