Forex Trading - An introduction

A Little Forex History

The purpose of these articles is to introduce the forex market to you. As with many markets there are many derivative of the central market such as futures, options and forwards. In this book we will only be discussing the main market sometime referred to as the Spot or Cash market.

The word FOREX is derived from the words Foreign Exchange and is the largest financial market in the world. Unlike many markets the FX market is open 24 hours per day and has an estimated $1.2 Trillion in turnover every day. This tremendous turnover is more than the combined turnover of the main worlds' stock markets on any given day. This tends to lead to a very liquid market and thus a desirable market to trade.

Unlike many other securities (any financial instrument that can be traded) the FX market does not have a fixed exchange. It is primarily traded through banks, brokers, dealers, financial institutions and private individuals.

Trades are executed through phone and increasingly through the Internet. It is only in the last few years that the smaller investor has been able to gain access to this market. Previously the large amounts of deposits required precluded the smaller investors. With the advent of the Internet and growing competition it is now easily within the reach of most investors.

INTERBANK

You will often hear the term INTERBANK discussed in FX terminology. This originally, as the name implies was simply banks and large institutions exchanging information about the current rate at which their clients or themselves were prepared to buy or sell a currency.

INTER meaning between and Bank meaning deposit taking institutions. The market has moved on to such a degree now that the term interbank now means anybody who is prepared to buy or sell a currency.

It could be two individuals or your local travel agent offering to exchange Euros for US Dollars. You will however find that most of the brokers and banks use centralized feeds to insure reliability of quote.

The quotes for Bid (buy) and Offer (sell) will all be from reliable sources. These quotes are normally made up of the top 300 or so large institutions. This insures that if they place an order on your behalf that the institutions they have placed the order with is capable of fulfilling the order.

Now although we have spoken about orders being fulfilled, it is estimated that anywhere from 70%-90% of the FX market is speculative. In other words the person or institution that bought or sold the currency has no intention of actually taking delivery of the currency. Instead they were solely speculating on the movement of that particular currency.

 Extract From The Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity.

 

 

As you can see from the above table over 90% of all currencies are traded against the US Dollar. The four next most traded currencies are the Euro (EUR), Japanese Yen (JPY), Pound Sterling (GBP) and Swiss Franc (CHF).

As currencies are traded in pairs and exchanged one for the other when traded, the rate at which they are exchanged is called the exchange rate. These four currencies traded against the US Dollar make up the majority of the market and are called major currencies or the majors.

As you can see from the above table over 90% of all currencies are traded against the US Dollar. The four next most traded currencies are the Euro (EUR), Japanese Yen (JPY), Pound Sterling (GBP) and Swiss Franc (CHF).

As currencies are traded in pairs and exchanged one for the other when traded, the rate at which they are exchanged is called the exchange rate. These four currencies traded against the US Dollar make up the majority of the market and are called major currencies or the majors.

Market Mechanics

So now we know that the FX market is the largest in the world and that your broker or institution that you are trading with is collecting quotes from a centralized feed or individual quotes comprising of interbank rates.

So how are these quotes made up? Well, as we previously mentioned currencies are traded in pairs and are each assigned a symbol. For the Japanese Yen it is JPY, for the Pounds Sterling it is GBP, for Euro it is EUR and for the Swiss Frank it is CHF. So, EUR/USD would be Euro-Dollar pair. GBP/USD would be pounds Sterling-Dollar pair and USD/CHF would be Dollar-Swiss Franc pair and so on.

You will always see the USD quoted first with few exceptions such as Pounds Sterling, Euro Dollar, Australia Dollar and New Zealand Dollar. The first currency quoted is called the base currency. Have a look below for some example.

 

When you see FX quotes you will actually see two numbers. The first number is called the bid and the second number is called the offer (sometimes called the ASK).

If we use the EUR/USD as an example you might see 0.9950/0.9955 the first number 0.9950 is the bid price and is the price traders are prepared to buy Euros against the USD Dollar. The second number 0.9955 is the offer price and is the price traders are prepared to sell the Euro against the US Dollar.

These quotes are sometimes abbreviated to the last two digits of the currency such as 50/55. Each broker has its own convention and some will quote the full number and others will show only the last two.

You will also notice that there is a difference between the bid and the offer price and that is called the spread. For the four major currencies the spread is normally 5 give or take a pip (will explain pips later)

To carry on from the symbol conventions and using our previous EUR quote of 0.9950 bid, that means that 1 Euro = 0.9950 US Dollars. In another example if we used the USD/CAD 1.4500 that would mean that 1 US Dollar = 1.4500 Canadian Dollars.

The most common increment of currencies is the PIP. If the EUR/USD moves from 0.9550 to 0.9551 that is one pip. A pip is the last decimal place of a quotation. The pip or POINT as it is sometimes referred to depending on context is how we will measure our profit or loss.

As each currency has its own value, it is necessary to calculate the value of a pip for that particular currency. We also want a constant so we will assume that we want to convert everything to US Dollars. In currencies where the US Dollar is quoted first the calculation would be as follows.

Example JPY rate of 116.73 (notice the JPY only goes to two decimal places, most of the other currencies have four decimal places)

In the case of the JPY 1 pip would be .01 therefore

USD/JPY: (.01 divided by exchange rate = pip value) so .01/116.73=0.0000856. It looks like a big number but later we will discuss lot (contract) size later.

USD/CHF: (.0001 divided by exchange rate = pip value) so .0001/1.4840 = 0.0000673

USD/CAD: (.0001 divided by exchange rate = pip value) so .0001/1.5223 = 0.0001522

In the case where the US Dollar is not quoted first and we want to get to the US Dollar value we have to add one more step.

EUR/USD: (0.0001 divided by exchange rate = pip value) so .0001/0.9887 = EUR 0.0001011 but we want to get back to US Dollars so we add another little calculation which is EUR X Exchange rate so 0.0001011 X 0.9887 = 0.0000999 when rounded up it would be 0.0001.

GBP/USD: (0.0001 divided by exchange rate = pip value) so 0.0001/1.5506 = GBP 0.0000644 but we want to get back to US Dollars so we add another little calculation which is GBP X Exchange rate so 0.0000644 X 1.5506 = 0.0000998 when rounded up it would be 0.0001.

By this time you might be rolling your eyes back and thinking do I really need to work all this out, and the answer is no.

Nearly all the brokers you will deal with will work all this out for you. They may have slightly different conventions, but it is all done automatically. It is good however for you to know how they work it out. In the next section we will be discussing how these seemingly insignificant amounts can add up.

More On Market Mechanics

Spot Forex is traditionally traded in lots also referred to as contracts. The standard size for a lot is $100,000. In the last few years a mini lot size has been introduced of $10,000 and this again may change in the years to come.

As we mentioned on the previous page currencies are measured in pips, which is the smallest increment of that currency. To take advantage of these tiny increments it is desirable to trade large amounts of a particular currency in order to see any significant profit or loss. We shall cover leverage later but for the time being let's assume that we will be using $100,000 lot size. We will now recalculate some examples to see how it effects the pip value.

USD/JPY at an exchange rate of 116.73

(.01/116.73) X $100,000 = $8.56 per pip

USD/CHF at an exchange rate of 1.4840

(0.0001/1.4840) X $100,000 = $6.73 per pip

In cases where the US Dollar is not quoted first the formula is slightly different.

EUR/USD at an exchange rate of 0.9887

(0.0001/ 0.9887) X EUR 100,000 = EUR 10.11 to get back to US Dollars we add a further step

EUR 10.11 X Exchange rate which looks like EUR 10.11 X 0.9887 = $9.9957 rounded up will be $10 per pip.

GBP/USD at an exchange rate of 1.5506

(0.0001/1.5506) X GBP 100,000 = GBP 6.44 to get back to US Dollars we add a further step

GBP 6.44 X Exchange rate which looks like GBP 6.44 X 1.5506 = $9.9858864 rounded up will be $10 per pip.

As we said earlier your broker might have a different convention for calculating pip value relative to lot size but however they do it they will be able to tell you what the pip value for the currency you are trading is at that particular time. Remember that as the market moves so will the pip value depending on what currency you trade.

So now we know how to calculate pip value lets have a look at how you work out your profit or loss. Let's assume you want to buy US Dollars and Sell Japanese Yen. The rate you are quoted is 116.70/116.75 because you are buying the US you will be working on the 116.75, the rate at which traders are prepared to sell.

So you buy 1 lot of $100,000 at 116.75. A few hours later the price moves to 116.95 and you decide to close your trade. You ask for a new quote and are quoted 116.95/117.00. As you are now closing your trade and you initially bought to enter the trade you now sell in order to close the trade and you take 116.95 the price traders are prepared to buy at. The difference between 116.75 and 116.95 is .20 or 20 pips. Using our formula from before, we now have (.01/116.95) X $100,000 = $8.55 per pip X 20 pips =$171

In the case of the EUR/USD you decide to sell the EUR and are quoted 0.9885/0.9890 you take 0.9885. Now don't get confused here. Remember you are now selling and you need a buyer. The buyer is biding 0.9885 and that is what you take. A few hours later the EUR moves to 0.9805 and you ask for a quote.

You are quoted 0.9805/0.9810 and you take 0.9810. You originally sold EUR to open the trade and now to close the trade you must buy back your position. In order to buy back your position you take the price traders are prepared to sell at which is 0.9810. The difference between 0.9810 and 0.9885 is 0.0075 or 75 pips. Using the formula from before, we now have (.0001/0.9810) X EUR 100,000 = EUR10.19: EUR 10.19 X Exchange rate 0.9810 =$9.99($10) so 75 X $10 = $750.

To reiterate what has gone before, when you enter or exit a trade at some point your are subject to the spread in the bid/offer quote. As a rule of thumb when you buy a currency you will use the offer price and when you sell you will use the bid price.

So when you buy a currency you pay the spread as you enter the trade but not as you exit and when you sell a currency you pay no spread when you enter but only when you exit.