Tag: stocks

Forex Trading; “dollar cost averaging”

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Forex has many benefits over other investment vehicles.  Trades in Forex have their own set of rules.  By combining certain strategies used and modified in other securities they can be optimized for trading in the Forex market.  One thing that commonly is used and taught in securities trading is the concept of dollar cost averaging.  This is when you buy a security such as a stock, it goes down in price instead of up as you expected and you buy more to lower you overall cost per share.  An example would be: you buy 100 shares of xyz corp at $10 per share.  The price then drops to $9 per share and you buy another 100 shares.  By doing this you now average $9.5 per share.  If you bought at $10 per share and the price dropped to $5 and you bought another $100 your average cost would be $7.50 per share.  So the stock would only have to go back up to $7.50 for you to break even.  Even though you bout half of your stock at $10.  Anything now over $7.50 and you are in profit.  This is dollar cost averaging.

     This tactic is often used when purchasing many stocks and other investment vehicles.  Although this can be a great strategy for stocks, it doesnt work as well when used in Forex trading.  The reason that it can be a good strategy for stocks is because people use this when they plan on a buy and hold.  This is an important concept to make it work.  BUY;  normally when purchasing stocks they are bought and paid for.  You won’t get a margin call if the stock goes down if you pay for the stock.  HOLD;  normally the stock is purchased with the intent to keep them long term and hold them for either dividend payments and/or appreciation.

     Because Forex is completely differnt than stocks neither of these apply, and here is why.  When you enter a “buy” or “sell” position in Forex you dont really buy it.  You dont really “own” the currency that you “bought”.  You actually entered a trade comparing two currencies, betting on whether one currency will increase or decline in value vs. the other currency.  These are called “Pairs” or “Currency Pairs”.  This is a huge distinction because not actually owning a currency, but meerly owning a position leaves you open to actual losses.  This is what I mean;  if you purchased a stock or an actual currency say Google stock or the British Pound, then you will still have those and never owe money.  You already bought it and own it.  But in Forex trading you dont actually own a currency, you own a position “a bet or wager” on a pair of currrencies.  

     Lets say you bout British Pounds while traveling and held on to them.  It will never be worth $0 and you certainly couldnt owe anyone for having physical bills in your wallet or Pounds in your bank account.  The percieved value of that Pound may go up and down compared to other currencies in the world, but you still have the money, and you cant owe on it.  When trading currency pairs you can actually lose Everything, meaning the value of your position “investment” can be absolutely Worthless.  Even worse, you can actually lose money by owning it, ending up with a loss and a debit from your account.  If you deposited British pounds into your bank or brokerage account your balance would never go down.  If you bought “or sold” a currency pair with British pounds in your account you can actually owe the brokerage money!  If the pair you own against the Pound goes down, it will show a negative amount on your home screen.  

     The idea of holding a currency pair is not how it is done.  You enter a trade or position in a currency pair to unload as fast as it will move up or down.  We enter Forex trades for short term movements and gains.  For this reason the holding strategy doesnt work with Forex.  We buy and sell as fast as we possibly can.

     For these two reasons dollar cost averaging does not work with trading Forex pairs/positions.  Most of the time, as a general rule, the markets move in normal cycles.  There are swings of ups and downs and that is completely healthy and normal.  “Market corrections” “bubbles”, these all happen.  Its part of the industry.  So imagine you purchased Netflix shares at $25/share.  You bought 100 shares (for easy math purposes).  Your average cost is $25/share.  Then 2 months later they miss a projection and lose a contract and the stock plunges down to $15/share.  At this time if the fundamentals of the company and your opinion of its health and growth have not changed then you found the perfect opportunity to buy more “on sale”.  Great buy because you know its just a normal swing in the cycle and you got a great deal on another 100 shares.  Now your cost per share is $20!  Now when it goes back up to $25 you are already at 20% profit!

     However, if you bought a currency pair in the Forex market and the same movement happens, it could cause a Catastrphic chain of events!  If you are heavily leveraged (which most people are and do in Forex) you could lose your entire account from this one position owned.  This is why;  Lets say you built your $100 to $600 in your account.  Very nice job.  You enter a position in a Pair and it goes the wrong direction.  You think it will come back up (and it probably will), however time works against you in Forex.  If it falls too low before it comes up you lose it all.  Your position goes down and you will see a negative amount on your screen.  That negative number will keep increasing and you watch your margin shrink on screen.

 

 

 This may be only 1 of 12 trades or postions that you are in right now, but that one will bring the Entire house down.  When your negative number gets to a certain percentage the brokerage house will Automatically trigger a sale at that huge lose!  Yes.  And it get worse.  Now your other positions cannot sustain the low margin level because you just lost a huge portion of what was in your account.

 

This will cause Another auto trading trigger by your broker to sell off the next highest losing position in your account!  Giving you Another huge percentage lose.

 

Then it happens again!

 

And again!

 

Until Every position is sold at a loss.  Dollar cost averaging is Not the only way to trigger this chain of events in Forex, but it is the one that most fall victim to.

 

 

These are screenshots of this actually happening to a trader.  Eventually, (within hours) his entire account was sold off at a loss by his broker.  This investor managed to build $100 ito almost $1,000 in just over a month!  Then, in just a matter of hours he watched it ALL leave his account!

 

 

Once this chain of events happens there is little or Nothing you can do to stop it except make an Immediate deposit into the account to cover the negative margin level until the Pair turns the other direction!

 

As you can see, the free margin is in the negative, which means that you cannot make Any more trades.  If you had free margin left you could possibly make a quick profitable trade to increase the margin ration to stop an auto sale.  But as you see here, dollar cost averaging kills that option.

 

The currency Pair kept dropping in value and when the Free Margin level became a higher dollar amount than the Equity, the auto sales triggered!  One by one, in a matter of minutes now the investor lost his Entire account balance!

 

Lets look at why most fall into this trap.  As you see in the screen shots below that this investor did many trades on the Peso Pair.  It was running up and down and he was catching the waves of volatility.  

 

 

He had money both when it went up and down.  Goes up he keeps making money.

 

 

He made money when it went down.

 

 

He kept making money when it went down, believing it would always go back up before the margin threshold was hit.

 

 

So still believing that it would again come back up, he tried to dollar cost average (greed in Forex) and make extra money on the way back up.  However it did not turn upwards in time and his account was Completely emptied by auto trades triggered, forced on him by the brokerage house.

     In just a few minutes he watched weeks of work building his $100 into almost $1,000 shrink to $.59 in his account.

 

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