Forex Trading Examples (part 3)
Below is an example of a negative Risk/Reward ratio:
Buy USD/JPY 100,000 at 110.00
T/P Sell USD/JPY 100,000 at 110.30
S/L Sell USD/JPY 100,000 at 108.00
In the above example the take-profit is 30 pips higher than the level at which the position was entered, and the stop-loss is 200 pips lower than the level at which the position was entered. The Risk/Reward ratio is 1:0.15.
Below are examples of both a winning trade and losing trade when trading for a 10 pip profit or loss:
Buy EUR/USD at 1.2020 (price = 17/20)
Sell EUR/USD at 1.2030 (price = 30/33)
Market moves 13 pips before taking profit
Buy EUR/USD at 1.2020 (price = 17/20)
Sell EUR/USD at 1.2010 (price = 10/13)
Market moves 7 pips before taking loss
The above example highlights that the risk/reward of trading for a 10 pip profit or loss is very poor. For the same 10 pips P&L, the market must move 13 pips for your winning position, but only 7 pips for your losing position. For currency pairs quoted in 5-10 pip prices, obviously the risk/reward is even worse.
Here is an example of a reasonably profitable month for a successful trader. Let's imagine that his total capital is $20,000 and risk appetite per trade is 5%. This would mean he is willing to lose upto $1000 per trade. He always trades using a 100% Risk/Reward ratio (meaning that his stop-loss orders are the same distance as his profit-take orders, from the position entry level):
No. of Trades = 20
Winning Trades = 12
Losing Trades = 8
Total Profit = $4000
REO/month (Return on Equity) = 20%
The example shows that he got 60% of his trades right and made an REO of 20% for the month and he only risked 5% of his capital on every trade.
An investor has a margin deposit with Saxo Bank of USD100,000.
The investor expects the US dollar to rise against the Swiss franc and therefore decides to buy USD2,000,000 - his maximum possible exposure.
The dealer quotes him 1.5515-20. The investor buys USD at 1.5520.
Day 1: Buy USD2,000,000 vs CHF 1.5520 = Sell CHF3,104,000.
Four days later, the dollar has actually risen to CHF1.5745 and the investor decides to take his profit.
Upon his request, the Saxo Bank dealer quotes him 1.5745-50. The investor sells at 1.5745.
Day 5: Sell USD2,000,000 vs CHF 1.5745 = Buy CHF3,149,000.
As the dollar side of the transaction involves a credit and a debit of USD2,000,000, the investor's USD account will show no change. The CHF account will show a debit of CHF3,104,000 and a credit of CHF3,149,000. Due to the simplicity of the example and the short time horizon of the forex market trading, we have disregarded the interest forex rate swap that would marginally alter the profit calculation.
This results in a profit of CHF45,000 = approx. USD28,600 = 28.6% profit on the deposit of USD100,000.
The investor follows the cross forex rate between the Euro and the Japanese yen. He believes that this market is headed for a fall. As he is less confident of this forex market trading, he does not fully use the leverage available on his deposit. He chooses to ask the dealer for a quote in EUR1,000,000. This requires a margin of EUR1,000,000 x 5% = EUR50,000 = approx. USD52,500 (EUR/USD1.05).
The dealer quotes 112.05-10. The investor sells EUR at 112.05.
Day 1: Sell EUR1,000,000 vs JPY 112.05 = Buy JPY112,050,000.
He protects his position with a stop-loss order to buy back the euro at 112.60. Two days later, this stop is triggered as the euro strengthens short term in spite of the investor's expectations.
Day 3: Buy EUR1,000,000 vs JPY 112.60 = Sell JPY112,600,000.
The EUR side involves a credit and a debit of EUR1,000,000. Therefore, the EUR account shows no change. The JPY account is credited JPY112.05m and debited JPY112.6m for a loss of JPY0.55m. Due to the simplicity of the example and the short time horizon of the forex market trading, we have disregarded the interest forex rate swap that would marginally alter the loss calculation.
This results in a loss of JPY0.55m = approx.USD5,300 (USD/JPY 105) = 5.3% loss on the original deposit of USD100,000.
The investor believes the Canadian dollar will strengthen against the US dollar. It is a long term view, so he takes a small position to allow for wider swings in the forex rate:
He asks dealer for a quote in USD1,000,000 against the Canadian dollar. The dealer quotes 1.5390-95 and the investors sells USD at 1.5390. Selling USD is the equivalent of buying the Canadian dollar.
Day 1: Sell USD 1,000,000 vs CAD 1.5390. He swaps the position out for two months receiving a forward forex rate of CAD1.5357 = Buy CAD1,535,700 for Day 61 due to the interest forex rate differential.
After a month, the desired move has occurred. The investor buys back the US dollars at 1.4880. He has to swap the position forward for a month to match the original sale. The forward forex rate is agreed at 1.4865.
Day 31: Buy USD1,000,000 vs CAD 1.4865 = Sell CAD1,486,500 for Day 61.
Day 61: The two forex market trades are settled and the forex market trades go off the books. The profit secured on Day 31 can be used for margin purposes before Day 61.
The USD account receives a credit and debit of USD1,000,000 and shows no change on the account. The CAD account is credited CAD 1,535,700 and debited CAD 1,486,500 for a profit of CAD49,200 = approx. USD33,100 = profit of 33.1% on the original deposit of USD100,000.
Foreign currency exchange rates are what it costs to exchange one country's currency for another country's currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs and other expenses in British pounds. Since your money is all in US dollars, you will have to use (sell) some of your dollars to buy British pounds.
Assume you go to your bank before you leave and buy $1,000 worth of British pounds. If you get 565.83 British pounds (£565.83) for your $1,000, each dollar is worth .56583 British pounds. This is the exchange rate for converting dollars to pounds.
If £565.83 isn't enough cash for your trip, you will have to exchange more US dollars for pounds while in England. Assume you buy another $1,000 worth of British pounds from a bank in England and get only £557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to .55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation.
Assume that you have ??100 left when you return home. You go to your bank and use the pounds to buy US dollars. If the bank gives you $179.31, each British pound is worth 1.7931 dollars. This is the exchange rate for converting pounds to dollars.
Theoretically, you can convert the exchange rate for buying a currency to the exchange rate for selling a currency, and vice versa, by dividing 1 by the known rate. For example, if the exchange rate for buying British pounds with US dollars is .56011, the exchange rate for buying US dollars with British pounds is 1.78536 (1 ?·.56011 = 1.78536). Similarly, if the exchange rate for buying US dollars with British pounds is 1.78536, the exchange rate for buying British pounds with US dollars is .56011 (1?·1.78536 = .56011). This is how newspapers often report currency exchange rates.