The Young Investors Guide to Forex Part 2 - The Real Risk and Profits from Forex

Updated 23 Jul 2015 – By Loanstreet


There may be many questions left unanswered from Part 1. What is leverage? What are the risks of Forex? What are the tools to protect me from the risk? Follow closely and don’t get lost as we answer all of your question in our Part 2 guide to Forex series!

Leverage

To maximize your profit, one of the most powerful tools Forex offers is leverage. Leverage allows you to trade more than you can afford, essentially amplifying both your losses and profits.

In general, leverage for investment can be split into two component the original amount you put in and the amplified ratio under the leverage amount.


forex leverage ratio

Your final amount after leverage can be calculated by

Final Amount = Leverage Ratio x Original Amount 

Let’s say if you have a balance equity of 1,000 USD in your account and you are using a leverage of 50:1.

forex leverage ratio

You would be available to trade up to 50k USD worth of currency!

*Note that we did not use cash when we specified the 1,000 USD here because balance equity includes cash and all your open positions profit and loss. Open position profit and loss is the profit and loss earned by your currently bought currency pairs, even though you have not closed (sold) them yet.

For example, if you have 1,000 USD and sold a Forex USD/EUR currency pair with a leverage of 50:1 during 1st June 2015 and held for a month as Option 1, to compare with; if you have used a similar 1,000 USD with a leverage of 2:1 to invest into Time Dotcom Bhd (one of the best performing stock in Malaysia in 2015) as Option 2, how will your profit comparison look like?

forex and stocks comparison

The winner here is very clear. With close to 90% return on investment, buying stocks do not even come close to the profit provided by Forex earnings. However, if you observe carefully, the price of Time dotcom Sdn BHD have definitely risen more than the currency pair. The key difference here is the leverage amount that both investment options provide. In this case, by purchasing currency with a 50:1 leverage, you are actually amplifying your profit by 50 times!

Of course if you happen to make a wrong choice and had bought EUR/USD, you would end up with a massive loss.

buying USD/EUR

With an initial investment amount of 1,000 USD equivalent to 916 Euro, you have already lost around 95 % of your investment.

Limiting your Risk: Technical Analysis

Most Forex traders use technical analysis to decide their day-to-day trading while paying attention to global news so that they can make adjustments if there are any major incidents that could alter the currency’s value.

Technical analysts look at the past trends of the market to predict the future trends of the market, disregarding intrinsic value of the currency itself.

USD/EUR

Above is a candlestick chart, one of the more popular charts used during currency valuation. In order to evaluate whether a currency is worth buying or not, one of the more popular method used is technical analysis.

Can you see the blue circle in the candlestick chart, going up and down just like sea waves?

Currency movements are exactly like waves they come in high or low. In order to gain profit, it is important to get into one of these “waves” as soon as possible so you can profit from the movement, and exit the “waves” as soon as it starts to go to the other direction.

 

Limiting Your Loss: Limit Orders

Of course, hindsight is 20/20. Even the most experienced trader could make wrong predictions regarding the movement of currency because trend analysis essentially is still based on speculation and predictions. Therefore even if you managed to reduce the probability of a loss occurring, you might still want to limit your loss to a certain amount to prevent a huge change in currency trend causing problems for your cash flow.

To limit losses, Forex traders often rely on electronically controlled limit orders to minimize your loss amount. Limit orders specify a price level and automatically closes your position if the price reaches that certain target level. Limit orders are flexible and can be used for different goals.

Going back to the example when you are buying EUR/USD, if you had put a stop loss/order on 0.905, you would have limited your lost significantly.

USD/EUR

buying USD/EUR with limit

 

There you go! Just by placing the stop loss order, you will already know that your maximum loss will be capped to a certain amount because once it reaches this point, it will automatically close at this position.

Another reason you might want to use limit orders is to take a certain amount of gain then exit the trade before the currency goes in the opposite direction. For example, when selling USD/EUR, you might think let’s not be too greedy and go for unlimited profit while risking a huge loss. Why not just stop at a limited profit and exit the trade safely thereafter?

Let’s say if we put a limit order on 0.895 USD/EUR when selling USD.

USD/EUR

According to the graph, during June 4th, the price would reach 0.895 and you would automatically buy it at that point.

Selling USD/EUR with limit                                    

You would gain 815.64 USD which is much more than you would when not imposing a limit! From this it should be clear now that limit orders can also help you to earn profit because you automatically exit the trade before it starts to go in the other direction.

Another very popular limit order is a buy stop order. It may trigger a buy option once the price reaches a certain level. For example, when looking at EUR/USD you speculate that it will start dropping. You are not confident to buy it right now but you are also afraid that when you wake up the next day the drop “wave” might be over already. A buy stop order will be your best tool here.

 

Conclusion

As you can see, there is no such thing as guaranteed returns in Forex trading, however there are tools that can help you make your own analysis (increase your percentage of making a profit) and limiting your loss (limit orders)

Remember that although Forex trading can make you rich within one night, it can also make you broke within minutes. Use your leverage and limit orders wisely to limit your loss. Our final advice to all the young adults is “don’t be greedy when you see people earning thousands a day while you only earns hundreds a month”. Remember that “slow and steady wins the race”!

 

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