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Foreign Exchange Order Types
A trader has at his disposal different foreign exchange order types to make foreign exchange trades. A clear understanding of each type of foreign exchange order is necessary to be a successful foreign exchange trader. The followings are typical foreign exchange orders that are executed every day by foreign exchange traders.
Foreign Exchange Market Orders This is the simplest foreign exchange order to place. A market order is a foreign exchange order to buy or sell a currency at the current market price. When placing a foreign exchange market order, the foreign exchange trader only has to specify the currency pair he wants to buy or sell (GBP/USD, USD/JPY, etc.) and the number of lots he is interested in buying or selling. The Ask price is the price the trader will pay when buying and the Bid price is the price he will receive when selling.
Foreign exchange brokers guarantee immediate fills on every foreign exchange market order up to US$1 million. If a foreign exchange broker is unable to secure the foreign exchange order at the specified rate, new pricing representing the current market rate will be sent to the client. Under no circumstances will a foreign exchange order be filled without client approval.
Placing a foreign exchange market order over the phone is just as easy. A trader will ask the foreign exchange dealer to buy or sell a specific number of lots of a specific currency after obtaining a two-way quote from the dealer.
A foreign exchange market order can be used to enter or exit a trade. Foreign exchange market orders should be used with care because in fast-moving markets there may be a difference between the price seen at the time a foreign exchange market order is given and the actual price of the transaction. This is due to slippage: the amount the market moves in the few seconds between giving a foreign exchange order and having it executed. Slippage could result in a loss or gain of several pips.
Foreign Exchange Limit Orders In a foreign exchange limit order, the trader not only specifies the currency he wants to buy or sell and the number of contracts, but also at which price he wants to do so; in other words, a limit is a foreign exchange order to buy or sell at a specified price or better.
Example: Let's say that a trader places a foreign exchange limit order to buy 2 lots of GBP/USD at 1.9170. This means that the foreign exchange order can only be executed at a price equal to 1.9170 or lower (lower is always better for the buyer).
Foreign exchange limit orders can be used to buy currency below the market price or sell currency above the market price. When buying, your foreign exchange order is executed when the market falls to your foreign exchange limit order price. When selling, your foreign exchange order is executed when the market rises to your foreign exchange limit order price. There is no slippage with foreign exchange limit orders.
Foreign Exchange Stop Orders The stop order is a foreign exchange order that is activated when a currency reaches a specified price called the "stop". This foreign exchange order becomes a normal market order when the quoted price reaches a specified level. Foreign exchange stop orders can be used to enter the market on momentum (like when a resistance or support level is broken), to limit the potential loss after establishing a position, and to protect the profit of an existing position that has moved favourably in price. In foreign exchange trading, foreign exchange stop orders are very important. Consequently, all traders that want to participate in the foreign exchange market should learn how to use this foreign exchange order properly.
Example: Protecting an existing position with a foreign exchange stop order: This is commonly known as a foreign exchange stop-loss order as it limits losses if the market moves contrary to what the trader expected. A foreign exchange stop-loss order will sell the currency if the market falls below the point set by the trader.
Suppose, a day trader buys 100,000 (1 lot) of EUR/USD at 1.1355 in anticipation of an expected 80 pip rally in the euro. In order to control his risk, the trader places a foreign exchange stop order 1.1335 (20 pips below the current price). If the price of the euro was to drop, the trader's loss would be limited to 20 pips ($200).
Example: Using a foreign exchange stop order to buy on momentum: A foreign exchange trader expects the U.S. dollar to rally against the Japanese yen, but does not want to buy yet because the USD/JPY is approaching a short-term resistance at 118.00. The foreign exchange trader instead places a buy foreign exchange stop order 10 pips above the resistance level. His stop is thus placed at 118.10. After this point, unless the USD/JPY goes to 118.10, the foreign exchange order won't be activated. By doing this, the trader is waiting for the resistance on the USD/JPY to be broken before entering the trade; i.e., he is waiting for the upward momentum on the dollar to be confirmed before buying.
One Cancels the Other (OCO): This foreign exchange order is used when placing a limit order and a stop-loss order at the same time. If either foreign exchange order is executed the other is cancelled, allowing the trader to make a transaction without monitoring the market. If the market falls, the stop-loss order will be executed, but if the market rises to the level of the foreign exchange limit order, the currency will be sold at a profit.
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There are 4 types of foreign exchange stop-orders in foreign exchange.
1. Equity Stop This is the simplest of all stops. The trader risks only a predetermined amount of his or her account on a single trade. A common metric is to risk 2% of the account on any given trade. On a hypothetical $10,000 trading account, a trader could risk $200, or about 200 points, on one mini lot (10,000 units) of EUR/USD, or only 20 points on a standard 100,000-unit lot. Aggressive traders may consider using 5% equity stops, but note that this amount is generally considered to be the upper limit of prudent money management because 10 consecutive wrong trades would draw down the account by 50%. One strong criticism of the equity stop is that it places an arbitrary exit point on a trader's position. The trade is liquidated, not as a result of a logical response to the price action of the marketplace, but rather to satisfy the trader's internal risk controls.
2. Chart Stop Technical analysis can generate thousands of possible stops, driven by the price action of the charts or by various technical indicator signals. Technically oriented traders like to combine these exit points with standard equity stop rules to formulate charts stops. A classic example of a chart stop is the swing high/low point. In the following figure, a trader with our hypothetical $10,000 account using the chart stop could sell one mini lot risking 150 points, or about 1.5% of the account.
3. Volatility Stop A more sophisticated version of the chart stop uses volatility instead of price action to set risk parameters. The idea is that in a high volatility environment, when prices traverse wide ranges, the trader needs to adapt to the present conditions and allow the position more room for risk to avoid being stopped out by intra-market noise. The opposite holds true for a low volatility environment, in which risk parameters would need to be compressed.
One easy way to measure volatility is through the use of Bollinger bands, which employ standard deviation to measure variance in price. The following two figures below show a high volatility and a low volatility stop with Bollinger bands, respectively. In the first figure the volatility stop also allows the trader to use a scale-in approach to achieve a better "blended" price and a faster breakeven point. Note that the total risk exposure of the position should not exceed 2% of the account; therefore, it is critical that the trader use smaller lots to properly size his or her cumulative risk in the trade.
4. Trailing Foreign Exchange Stop Orders A trailing foreign exchange stop order is a foreign exchange stop order that adjusts itself whenever the price moves by a specified amount in the trader's favour.
Example: Let's say that a foreign exchange trader that has a long, profitable USD/JPY position, needs to leave his computer. He can do one of two things:
5. Margin Stop This is perhaps the most unorthodox of all money management strategies, but it can be an effective method in foreign exchange trading, if used judiciously. Unlike exchange-based markets, foreign exchange markets operate 24 hours a day. Therefore, foreign exchange dealers can liquidate their customer positions almost as soon as they trigger a margin call. For this reason, foreign exchange customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.
This money management strategy requires the trader to subdivide his or her capital into 10 equal parts. In our original $10,000 example, the trader would open the account with an foreign exchange dealer but only wire $1,000 instead of $10,000, leaving the other $9,000 in his or her bank account. Most foreign exchange dealers offer 100:1 leverage, so a $1,000 deposit would allow the trader to control one standard 100,000-unit lot. However, even a 1 point move against the trader would trigger a margin call (since $1,000 is the minimum that the dealer requires).
So, depending on the trader's risk tolerance, he or she may choose to trade a 50,000-unit lot position, which allows him or her room for almost 100 points (on a 50,000 lot the dealer requires $500 margin, so $1,000 – 100-point loss* 50,000 lot = $500). Regardless of how much leverage the trader assumed, this controlled parsing of his or her speculative capital would prevent the trader from blowing up his or her account in just one trade and would allow him or her to take many swings at a potentially profitable set-up without the worry or care of setting manual stops. For those traders who like to practice the "have a bunch, bet a bunch" style, this approach may be quite interesting.
Some examples of foreign exchange order's transactions:
Example of OCO Transaction: Buy: 1 standard lot EUR/USD @ 1.3228 = $132,280 Pip Value: 1 pip = $10 Stop-Loss: 1.3203 Limit: 1.3328
This is a foreign exchange order to buy US dollars at 1.3328 and to sell them if they fall to 1.3203 (resulting in a loss of 25 pips or $250) or to sell them if they rise to 1.3328 (resulting in a profit of 100 pips or $1,000).
Here's another example:
Suppose, the current bid/ask price for US dollars and Canadian dollars is USD/CAD 1.2152/57 ...meaning you can sell $1 US for 1.2152 CAD or buy $1 US at 1.2157 CAD.
If you think that the US dollar (USD) is undervalued against the Canadian dollar (CAD) you would buy USD (simultaneously selling CAD) and wait for the US dollar to rise.
Buy USD: 1 standard lot USD/CAD @ 1.2157 = $121,570 CAD Pip Value: 1 pip = $10 Stop-Loss: 1.2147 Margin: $1,000 (1%)
You are buying US$100,000 and selling CAD$121,570. Your stop loss order will be executed if the dollar falls below 1.2147, in which case you will lose $100.
However, if USD/CAD rises to 1.2192/87. You can now sell $1 US for 1.2192 CAD or sell 1.2187 CAD for $1 US.
Because you entered the transaction by buying US dollars (buying long), you must now sell US dollars and buy back CAD dollars to realize your profit. You sell US$100,000 at the current USD/CAD rate of 1.2192, and receive 121,920 CAD for which you originally paid CAD$121,570. Your profit is $350 Canadian dollars or US$287.19 (350 divided by the current exchange rate of 1.2187).
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