Basic Strategies to Help You Trade Forex
There’s no doubt that money can lead to making more money, but when it comes to forex trading it is easier said than done. The international economy is extremely complex with a variety of macroeconomic factors affecting the strength of each nation’s currency. Generally, forex trading requires you to be more active than other types of investing. On top of that, most forex trading by individual investors typically occurs in derivatives markets adding another layer of complexity. However, this is where we will direct our focus when discussing the following strategies.
The main types of forex trading strategies.
Previously, we have published articles explaining the mechanisms of derivatives in general, as well as the specifics behind a few types in particular (link to derivative articles). If you’ve had a chance to read these pieces, then you may remember that derivatives are traded for two main reasons. These reasons include the use of hedging techniques, as well as for speculation. It then makes sense that derivative-related forex strategies generally fall under the same two headings of hedging and speculation. You may also remember that the two main derivatives used in these categories were options and futures. These will also be used here. However, it should be noted there are some more advanced trading techniques beyond these two that will be discussed in a later article.
Strategy #1 - Hedging
Let’s start by reminding you that derivatives are often used in conjunction with another underlying security. Although this isn’t always the case, it applies when it comes to hedging. So we’ve mentioned before how hedging is achieved through derivatives and it is quite similar in this case. However, there are some slight modifications.
We know that derivatives can be used as a hedging strategy in order to offset an unwanted movement of another asset price (for example, a particular company). Now let’s assume that this company operates in a global market and sells its products worldwide. Additionally, it has even set up operations in a foreign country. In this case, the company will be paid in foreign currencies. This means that a fall in the valuation of these foreign currencies translates into foreign revenues being worth less.
Undoubtedly, the underlying company’s stock price will be affected by this activity. Luckily, investors have a method of hedging against this through the use of forex. Here, the investor could also purchase a derivative that bets on the potential devaluation of the foreign currency in relation to the domestic currency. In the case that it does decrease in value, then the investor can exercise their option. This would help to offset any decreases in the underlying asset’s stock price. In the case that the foreign currency does not devalue, then the option holder simply decides not to exercise the option.
Strategy #2 - Speculation
The nature of forex speculation is very similar to speculation elsewhere in the investment world. Essentially, the investor takes a long or short position hoping that their judgment is right. This can be achieved through either options or futures. Just remember, that futures represent an obligation to carry out the contract, whereas the option isn’t obligatory. Since all forex trading occurs in pairs of currencies, speculators are betting on the increase or decrease of one currency relative to another. This requires an in-depth understanding of the factors affecting the relationship between two currencies. You can read our article here that discusses the factors affecting a nation’s currency relative to others in the international market (link to factors affecting forex article).
Forex Currency Pairs
As you have noticed, all forex trading involves a pair of two currencies. Speculation for example, typically occurs within more popular currency pairs since they are more liquid compared to others. We will discuss the four major pairs in an article to follow (article to come in February).
Automated Versus Manual Forex Trading
So there are also a couple of options in terms of how you decide to trade in forex. This includes manual versus automated trading. Of course, you can actively watch the markets and time your trades accordingly by executing everything on your own. This would be referred to as manual trading. However, there is also sophisticated software on the market which can automate a large portion of your forex trading. One aspect of this software is the use of limit orders, which we have previously discussed here (link to limit orders article). This way, you can take some of the stress off your plate and allow automated trading mechanisms to aid in your strategy. Though, we will leave the discussion about the nature of automated forex trading to a later article.
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