Do you understand your market?

In my previous articles, I described developing a trader's mindset and putting together a mission statement.

Now we need to consider the next three aspects of building a trading business.

1.What online broker to use.

2.What size account we need to fund.

3.What markets or currency pairs we want to trade.

Since this series of articles is focused on the Forex markets, we need to examine and understand the role of the online retail market makers, and how we as traders, interface with them.

Online Brokers

Online brokers are companies that have relationships with a select number of banks. Based on their own capitalization and credit worthiness, they are able to establish lines of credit with these banks that then provide them with access to their bid and offer prices. A good online market maker will aggregate a number of bank quotes and then offer the average bid and offer price to their own customers, after adjusting the spread they receive, to allow for some profit for themselves. The bigger the volume they can trade, the better the spreads they receive from their banks. It's a numbers game. But for the online trader, the counterparty to his trade is his market maker and not the banks directly.

So when opening an account with an online market maker a trader needs to be aware of the financial standing of the brokerage, whether they are in any way regulated by the CFTC, (Commodity Futures Trading Commission), an indication of good business practices, their policy and methodology of managing trades and stop losses, their margin requirements, whether they have a dealing desk in case your internet connection goes down, and so on. You must read your online broker's client agreement thoroughly.

The purpose of this brief overview of the online market maker's role is to bring your attention to the fact that choosing the right market maker is very important in terms of your ability to execute and manage your trading risk.

In summary, you want to be sure that you have an account with a reputable market maker who will provide you with the best possible execution; at the prices he posts and without re-quoting after you make the trade.

Proper Capitalization

Having a properly capitalized account is a very important consideration. Even though it is possible to open an account with an online broker with as little as $250 dollars, you have to ask yourself, Does this make sense?

If you have any understanding of the Forex market at all, you know that the smallest move a currency can make is one pip. (Actually some online market makers are now offering fractional pips). But for practical purposes consider a pip as the smallest possible move.

If the spread is typically between three to five pips per trade one way, then it will cost at least six to ten pips to open and close a position. If the value of a pip is $1, which is the case when trading dollar quoted currency pairs, such as EURO/USD and in a lot size of 10,000 units, then you have to wonder where you would have to place a stop loss order so that you don't lose 10% of your capital in the first trading loss you make.

One needs to take a realistic view of the actual currency pairs range of movement each period to see what range the currency will trade between the high and low and if entering a trade, how far away the stop loss order would have to be placed to give the currency enough wiggle room without getting stopped out for no real reason.

In the chart example below, a five minute chart of the USD/JPY (dollar-yen), a trade opportunity to go long the dollar is taken at 99.60, and the stop loss order is placed at 99.43. The risk in this trade is 17 pips. If you get stopped out of this trade, your cost will be the 17 pips.

From the perspective of this one trade, you are actually risking $17/$250 or 6.8% of your capital. If you funded your account with say, $5000 then you would be risking only .34% of your capital, about a third of 1%. You can see then that a well capitalized account is a far better cushion of protection than a skimpy $250.

Because you may be able to leverage your position 100:1, you will have to put up about $100 of your $250 capital to take this trade of 10,000 units. If you lose 17 pips, your capital will be reduced to $223.

Remember that as you reduce capital through a string of losses, your ability to margin different currencies becomes severely limited. Some currencies like the GBP/USD, require a much higher margin. If you want to buy or sell the gbpusd, and say it is trading at 2.0000, your margin requirement would be about $200.00.

In other words, you cannot really make money in Forex by being undercapitalized. Sure you can play for a few trades, but inevitably you will not be able to accomplish your goals of making reasonable money as a trader. In fact the odds are that you will probably dwindle away the $250 until you either have to top up your account or you quit altogether.

Which Forex Pairs to Trade

Finally, it is very important to understand the different trading patterns of each currency pair. Some currencies are less liquid, and therefore you will be faced with wider spreads, and possibly execution away from your desired level.

Some currency pairs tend to back and fill more, requiring that you place your stops out of harm's way but yet close enough to protect you in case of an adverse market move. By back and fill I mean the up and down movement in one bar or candle period. If you measure the high to low of each candle or bar and average these, you will find that many currencies have a range of 30 to 75 pips. If you place your stops too tight, the market will seem like your enemy every time.

Conclusion

As you can see, trading in the Forex markets takes some careful thought. Not only do we have to learn about the market and what causes currencies to move, but we have to set up our business so that we have a proper chance to execute our trades efficiently and manage our risks accordingly. I am sure you will agree with me that all the components discussed so far, namely a trader's mindset, good trading habits, a well thought out-mission or long-term strategy, a suitable and well respected broker who offers all the tools and access you need to have a properly funded trading account are the primary requisites for successfully building a Forex trading business.

Selwyn Gishen is a trader with over fifteen years experience trading forex and equities for a private equity fund. He is also a student of metaphysics for over thirty five years. He has written a book called "Mind - How Changing Your Mind, Can Change Your Life!"

Selwyn is the founder of FXNewsandViews.Com and the author of Trading the Forex Markets - A Foundation Course for Online Traders. The course is designed to provide the trader with all the aspects of the Fusion Trading Model. More information about Fusion Trading can be found at fxnewsandviews.com