6 Key Principles to Understand When Trading Currency Pairs

Even if you have experience trading stocks and other assets, the forex currency market is vastly different in terms of the data you need to analyze. 

Before you trade currency pairs, you need to have a strong understanding of the tactics involved in forex trade analysis as well as the trading rules and best practices that will set you up for sustained success. Here are the six key principles that every trader should know before they start trading with real money.

1. How to Read Each Indicator

Before you can use an indicator in your trading strategy, you need to understand how to properly read it. Each of these indicators has its own unique features and data points that inform the indicator. For this reason, you should always develop a strong familiarity with each indicator before incorporating it into your trading strategy.

Here’s a look at some of the most common forex indicators used, along with links for further information about how to use these analysis tools when trading currency pairs:

• Relative Strength Index (RSI): This indicator uses an oscillator set on a scale of 0-100. Price movements above 80 or below 20 on this indicator suggest that a currency pair is either overbought or oversold.

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• Moving Averages: Moving averages show a time-weighted average of a currency pair price to illustrate how a current price is performing relative to its value over a longer time frame. Different time periods may be used for the moving average calculation.
  
  
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• Bollinger Bands: These bands present a moving range of price action for a currency pair. When the price moves outside of the upper or lower ranges, it can indicate a possible reversal in price action.
  
  
• Moving Average Convergence-Divergence (MACD): This indicator uses two different moving averages to identify the strength, momentum, and likely direction of the movement for a currency pair.
  
  
• Fibonacci Levels: These levels are based on mathematical ratios and are so popular among traders that their identified levels of support and resistance can bear out in a live forex environment.

2. How to Understand Leverage in Forex Trading

If you want to increase the potential rewards—and the potential risks—of forex trading, you may be interested in taking advantage of your account’s leverage. Leverage in forex trading is similar to what you’ll find with many stock market brokerage firms: When a broker allows you to leverage your account, they are essentially offering to loan you investment funds based on the current value of your trading account.

At many forex brokerage firms, the amount of available leverage can be significant, with ratios of 50-to-1, 100-to-1, or even higher. With a 50-to-1 leverage opportunity, for example, an account with a $1,000 balance could trade with up to $50,000 in leverage, creating an opportunity for significant opportunities based on your initial investment.

However, the upside of leverage needs to be balanced out by the significant risk: If you take full advantage of that $50,000 leverage and lose 4% of your investment’s value, for example, you’ll suffer a loss of $2,000, which means you’ll wipe out your account balance and possibly owe your broker another $1,000 to cover your debt.

3. How to Calculate Margin for Your Brokerage Account

When you leverage your forex trading account, you will have an available investment amount based on how much you are currently leveraged in open positions. This amount is known as your “margin.”

If you’re able to access up to $50,000 in leveraged funds but have already made a $20,000 investment, for example, your margin amount may be around $30,000. Your margin can change based on the amount you have invested, the gains or losses of those investments, any deposits and withdrawals from your account, and/or whether your brokerage firm changes your available leverage.

4. How to Set Stop-Losses

Stop-losses are a critical tool for any forex trader. A stop-loss order is designed to offer security in the event of a currency pair’s price moving in the opposite direction. By placing a stop-loss order on the opposite side of your expected price movement, you can automatically trigger a sell-off of that position to minimize your losses when your forecasted action doesn’t take place as planned.

Without a stop-loss, you could quickly suffer significant losses—especially if you’re not actively monitoring your position. Meanwhile, if you predict price movements correctly, your position will gain in value, and the stop-loss will be irrelevant.

5. How to Find and Interpret Economic and Political News

Many other forex brokers and trading platforms integrate economic and other relevant news feeds into the platform itself, making it easy to find the right economic news and stay on top of current events.

In addition, you can also consult forex news websites and track report releases from governments across the globe. Many U.S. economic reports, for example, are scheduled for release at the same time every month, making it easy to know when and where to access this information.

6. How to Test and Reevaluate Your Trading Strategy

Once you’ve created a forex trading strategy based on the indicators, patterns, and evaluative processes you trust when opening and closing positions, you’ll need to test this strategy in a live environment. One option for testing this strategy is to create a demo account where you can make live trades using fake account funds, testing your trading strategy without exposing yourself to risk.

Alternatively, you can test this strategy using your actual account balance. Regardless of the path you choose, most experts agree that it takes at least 100 forex trades to compile a sample size large enough to fairly judge your strategy. If you rush to conclusions based on a handful of unsuccessful—or highly successful—trades, you may develop a skewed impression of your trading strategy. 

Give yourself time to let your trading strategy bear out—and then take a hard look at what changes, if any, might deliver better results.

As a forex currency trader, your trading principles are key to your success. Make sure your approach to trading currency pairs is underpinned by a strong foundational understanding of the principles that will play a role in leveraging this strategy for greater profit.