Our partners at INO MarketClub have a free short video about trading FOREX (i.e., currencies). Click here or either image to watch now.

In the beginning of July I wrote a post examining the US Dollar’s long-term 95% crash. (See “Who Killed the US Dollar?”) However, on Friday Bloomberg noted, “The dollar declined the most since May versus six major counterparts as the greenback became the cheapest funding currency, prompting investors to sell the dollar and buy riskier assets.” Looking at a one-year chart of the Dollar Index, we can see purchasing power continues to erode as select assets such as precious metals, oil, and stocks advance:

Dollar Index

So long as the Dollar remains trapped below the 50-day Moving Average, traders will continue to sell the rallies. Note how the peak in March is a nearly exact inversion of the S&P 500:

S&P 500

As we have been saying for months in our Premium Newsletter, the Dollar has continued to be the best indicator of where the stock market is headed. Short-term traders betting against the stock market rally will continue to get slaughtered if large global institutions are forced to buy stocks (and other assets) in an effort to escape US Dollar deflation.

To try a 14-day, no risk free trial of our Premium Newsletter, simply click here.

If you are interested in real-time market analysis, click here to follow Wall St. Cheat Sheet on Twitter.

As traders thirst for 24/7 access, FOREX continues to increase in popularity. I cannot surf any investing or trading site without a barrage of ‘FOREX Trading Account’ ads flashing like 42nd St. signage before Giuliani was mayor of NYC.

Currency trading became relatively popular during the recent bear market in the US Dollar. Basically, trend traders spotted a clean textbook trend. Then the heard flocked to the pastures. But FOREX is a complicated world full of governments, huge institutional traders, and 24/7 reactions to a global information stream.

I recently spoke with professional FOREX trader German Santos to help us figure out where to start. German, a former embedded hardware/software engineer known as pipmaestro on the StockTwits Recommended list, was kind enough to school us on the basics of FOREX trading.

German Santos

Damien Hoffman: German, what is the exchange called “FOREX”?

German: The foreign exchange (FOREX) market is the most liquid market in the world — far surpassing the combined average daily volume of the equities and futures markets. Central banks utilize the FOREX market to stabilize and protect the value of the nation’s currency. Banks facilitate trades on behalf of clients. Banks also speculate for their own accounts. Corporations with foreign exposure hedge their currency risk. Hedge funds and retail traders speculate and attempt to benefit from the interest rate yield. Finally, travelers require currency conversion services for use in countries visited.

Damien: What currencies trade on the FOREX?

German: The US dollar (USD), Euro dollar (Euro), Japanese yen (JPY), British pound (GBP, sterling or cable), Swiss franc (CHF or Swissy), Australian dollar (AUD or Aussie), New Zealand dollar (NZD or Kiwi) and Canadian dollar (CAD or Loony) are the most heavily traded currencies. The EURUSD, GBPUSD, USDCHF, USDJPY, USDCAD, AUDUSD and NZDUSD are amongst the most actively traded pairs. [Pairs are the relationship between two currencies.]

The US dollar is the world’s reserve currency. Most commodity prices are quoted in this currency. The European Union’s Euro is influential because the combined member state GDP approaches that of the United States. As a result, the EURUSD is arguably the most actively traded pair. The USD, JPY and CHF are known for their safe haven status.  The USDCAD, AUDUSD and NZDUSD are known as the commodity currencies because of their close correlation to oil, gold etc. The USDJPY, GBPJPY and other yen “crosses” had been used by traders implementing the carry trade strategy (described later) because of the yen’s virtual zero interest rate characteristic. Currency pairs such as the GBPJPY are known for their high intraday volatility, whereas the USDCHF is relatively stable. Currency pair characteristics are dynamic in nature and can change with time.

Damien: Can you explain how the currency “pairs” work?

German: The basic retail FOREX trading instrument is the currency pair. A transaction consists of the selling of one currency in exchange for the purchase of another. Let’s use the EURUSD pair as an example. An exchange of US dollars for Euro dollars occurs when you purchase the EURUSD pair. The EURUSD is purchased when there is an expectation that the Euro will increase in value relative to the US dollar. Conversely, an exchange of Euro dollars for US dollars occurs when you sell the EURUSD pair. The EURUSD is sold when there is an expectation that the US dollar will increase in value relative to the Euro.

Currency pairs are typically quoted to the second or fourth decimal place. Furthering our example, if the EURUSD quoted price = 1.4000, then 1.4000 US dollars are required to purchase 1 Euro dollar. If after purchase the value of the EURUSD pair increases to 1.4100, the transaction close will result in a net gain of 1 US penny per Euro returned (minus spread and commission). In conjunction with leverage and your account type, the penny gained on the EURUSD pair could represent anywhere from 1 US dollar (a nano account) to 1 thousand dollars (a standard account) per contract.

Damien: Can you explain how you arrived at those values?

German: For many currency pairs like the EURUSD, the smallest change in price occurs at the fourth decimal place (0.0001). For other pairs (like the yen pairs), the smallest change in price occurs at the customary second decimal place (0.01). The minimum change in price is called a pip (percentage in point). For our EURUSD example, a pip represents a value from 1 US penny to 10 US dollars — again depending on account type. The pair increased in value from 1.4000 to 1.4100, or 100 pips. For a nano account, 100 pips x 1 US penny per pip = 1 US dollar gained per contract.  For a standard account, 100 pips x 10 US dollars per pip = 1 thousand US dollars gained per contract. The actual monetary value of each 1 pip increment varies based on the chosen currency pair and account type. So always verify with your broker.

Damien: What is a “carry trade”?

German: In addition to profiting from the rise and fall of the currency value, the interest rate differential between the currency owned and currency sold will either add to or subtract from your account on a daily basis at the close of the session. Trades specifically designed to profit from this interest rate differential are known as “carry trades.” Of course, owning the currency with the inferior interest rate results in a debit to your account on a daily basis. The amount credited to or debited from your account per open trade varies with currency pair, position size, and broker. The yen crosses had been the classic example of the carry trade until recently when the interest rates of countries like the United States and Britain essentially migrated to yen levels.

Damien: If traders are serious about trading currencies, how do you recommend they proceed?

German: Choice of FOREX broker matters! Adequate broker capitalization is crucial. Go to http://www.cftc.gov/marketreports/financialdataforfcms/index.htm and download the latest month’s report. Stick with companies that have the highest capital structures and are engaged in a reasonable marketing campaign. The federal government continues to increase the capital requirements for FOREX brokers and each occurrence seems to cause a broker to go the way of the dodo bird!

Also, abandon all notions of getting rich quick. Because of leverage and due to the fact that even a broken clock is correct twice a day, the FOREX market can give you the illusion of being able to make a huge amount of money quickly. The market can randomly reward you for bad trading behavior. Until you execute your bad trading habit one too many times and the account proceeds to blow up. Capital preservation is critical simply because you need enough time to be able to discover those “bad trading habits.” Go slow. Preserve your capital. Learn the fundamentals. Achieve consistency.

The FOREX-industrial-complex will dazzle you with all types of entry/exit systems guaranteed to have you on your island sipping margaritas in no time. The entry/exit component, however, is just one leg of a three legged stool. Learn all you can about risk, money management, and trading psychology. Familiarize yourself with the concepts of position sizing, expectancy, risk-reward ratio, win-loss ratio, and the random re-enforcement mechanism. Books by Van Tharp, Alexander Elder, Mark Douglas and John Murphy will go a long way towards helping you understand the fundamentals of trading.

Ultimately, there is no substitute for practice, practice, practice. Screen time is crucial in helping you make the transition to consistency and ultimately profitability.

Damien: In your opinion, what are the best free FOREX resources on the web?

German: The best free FOREX education resources on the web that I have seen are: babypips.com and the education sections of informedtrades.com and learningmarkets.com.

Damien: German, thanks for all this great information! I hope you will come back and teach us more in the future.

German: Thank you, Damien. Enjoy the journey and I’ll see you on the field.

If you are interested in real-time market analysis and trades, click here to follow Wall St. Cheat Sheet on Twitter.

If you are interested in trading currencies, click here to follow German Santos.

Feel like sponging up more Trading Basics? Try these posts:

Trading 101: Fibonnaci Indicators with Pro Trader Abdel Ibrahim

Risk Management for Small Caps with Trader Kunal Desai

Top Three Mistakes New Traders Must Avoid

Getting Started Trading: The Setup