Tips For Choosing Your Trading Instrument In Forex Market
When it comes to choosing a trading instrument in the forex market, you do have a lot of options to consider. With an array of currency pairs and indices available, selecting the right trading instrument is crucial. Being a forex beginner, you might have a hard time choosing an appropriate asset or instrument for trading. In this article, you will get some useful tips for choosing your first-ever trading instrument in the forex market, helping you to make an informed choice.
Why is It Important to Choose the Right Trading Instrument in Forex?
Now, you might be wondering if the trading instrument you choose is that big of a deal in the trading process. It is true that the forex market is the most liquid and largest trading market, and you will always find trading opportunities irrespective of the asset you choose. However, you will have to choose the right instrument to make the most out of the trade. Along with that, you need to have access to the right trading tools, which can help you determine the right entry and exit points in a trade, along with other information.
Here are some key reasons why choosing the right assets to trade matters in forex:
- Volatility and Liquidity: Different currency pairs exhibit varying levels of volatility and liquidity. The same is true for major currency indices as well. Major currency pairs like EUR/USD, GBP/USD, and USD/JPY are highly liquid and typically less volatile. Exotic or minor currency pairs, on the other hand, can be more volatile and less liquid. Your trading strategy should align with the level of volatility you’re comfortable with.
- Risk Management: Proper asset selection plays a crucial role in risk management. Trading assets that are outside your risk tolerance can lead to substantial losses. For instance, focusing on major pairs with lower volatility is wise if you’re a risk-averse trader. On the other hand, volatile minor and exotic pairs would be a good match for those who are fine with the risk and want to focus on higher profit potential.
- Market Knowledge: Trading assets you are familiar with can give you a competitive edge. Understanding the economic and political factors affecting the currencies you trade enables you to make sound decisions and react swiftly to market developments. For instance, a trader from the EU will be familiar with the news and events that impact the Euro prices, and they might choose to trade pairs, including the Euro.
- Diversification: Diversifying your portfolio by trading a mix of currency pairs can help spread risk. However, choosing assets that aren’t highly correlated is essential to avoid overexposure to a particular economic region or event. But those who want to hedge the risk can choose to trade some correlated pairs by opening opposite positions. However, having a good amount of knowledge about currency correlation is essential for successful hedging.
- Time Zone Considerations: The Forex market operates 24 hours a day, five days a week, with different trading sessions around the world. Choosing assets that align with your trading hours can be advantageous, as you can better monitor and manage your positions. You need to check which pairs are most traded while you are active and stick to those to take advantage of the liquidity.
- Strategy Suitability: Your trading strategy may be better suited to specific currency pairs. For instance, scalpers often prefer highly liquid pairs with tight spreads, while swing traders may focus on pairs with broader price movements. Those who want to follow strategies like carry trading will have to look at pairs with ideal interest rate differential to profit from the swap. When it comes to trading popular indices like US30, your strategy will be a lot different. So, you need to make sure the instrument you choose perfectly aligns with your trading style and strategy.
Now that you have understood the reasons behind the relevance of choosing a suitable asset in forex, I will share some tips that you can follow for finding the best forex instruments for trading.
(1) Consider Your Budget for Trading: Your trading capital, or equity, is a fundamental factor in forex trading. It determines the size of your positions and the level of risk you can afford to take. If you have a small equity and limited experience, avoiding trading highly volatile currency pairs is better. High volatility means that prices can fluctuate rapidly, giving you a higher profit potential. But it also makes such pairs risky, as even a small adverse move can lead to substantial losses.
The trading cost that you have to pay in the form of spreads should also be considered while choosing pairs to trade with. Major pairs always have tight spreads, and EUR/USD has the lowest spread out of all pairs. Trading with such pairs increases your profitability by minimising the trading cost.
Starting with less volatile pairs allows you to manage risk more effectively as a beginner. As you gain experience and your equity grows, you can gradually move on to more volatile pairs. This approach helps you manage the risk and protect your account from losses during the initial stages of your trading journey.
(2) Consider Your Schedule: Forex markets operate 24/5, but not all assets are available for trading around the clock. Certain currency pairs are only tradable during specific market hours on weekdays. These assets lack liquidity when you try to trade them in any other session, making it difficult to enter and exit trades freely. Lack of liquidity, along with volatility, can result in excess slippage. This can have a negative impact on your trading results and needs to be avoided at all costs.
Hence, you need to find the perfect session when there are enough buyers and sellers for the pair. But you need to make sure that you can find time to trade during the major sessions. Your availability to trade is another crucial consideration. Full-time traders may be able to trade freely, while part-time traders will have to make some adjustments to find a pair that suits their schedule in trading.
Understanding your trading schedule lets you choose trading instruments that match your requirements. Or else, you might see yourself trying to enter trades while the chosen instrument is not actively traded. So, you need to consider the timing, and it is important to ensure you can actively manage your positions and make informed decisions with a flexible schedule.
(3) Consider Your Risk Tolerance: As I mentioned before, some amount of risk is always there in forex trading and understanding your risk tolerance is essential while choosing a trading instrument. Your risk level should influence your choice of trading assets. Selecting more stable and less volatile currency pairs is wise if you have a low-risk tolerance. These pairs are less likely to experience extreme price swings and are generally considered safer.
Conversely, you may opt for more volatile pairs if you have a higher risk tolerance and seek higher returns. However, being too risk-averse limits your profit potential, and you might miss out on good trading opportunities. So, you must strike a balance and consider your risk/reward ratio while making trading decisions. It’s crucial to align your choice of assets with your risk appetite to avoid excessive exposure.
Risk management is a crucial component in trading, and managing the risk requires a lot of calculations. These calculations may become complex for beginners, especially when trying to trade with multiple pairs with a different currency than your account’s base currency. Therefore, it is better to use basic forex tools like a currency calculator to get the right values without confusion.
(4) Consider Your Trading Goals: Your trading objectives play a significant role in asset selection. You should focus on long-term profitability with a strategy like position trading or short-term gains with day trading or scalping. It can also combine both, or you can stand in the middle with swing trading strategies. If you’re primarily interested in long-term trading, starting with low-volatility pairs that offer stability and potential for gradual growth would be ideal.
As you gain confidence and experience, you can consider more volatile pairs for potentially higher returns. On the other hand, if you’re looking for quick gains, high-volatility pairs might be appealing due to their potential for rapid price movements. However, beginners should not take that risk as the increased volatility can result in huge losses, and careful risk management is crucial.
In conclusion, choosing the right forex trading instrument is an important decision that needs to be taken after considering your equity, trading schedule, risk tolerance, and trading goals. A thoughtful and well-informed approach to asset selection can help you mitigate risk and increase your chances of success in forex trading.