Forex Basics

History of the Forex Market

The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of well over US$1 trillion -- 30 times larger than the combined volume of all U.S. equity markets.

"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).

There are two reasons to buy and sell currencies. About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency. The other 95% is trading for profit, or speculation.

For speculators, the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.

A true 24-hour market, Forex trading begins each day in Sydney, and moves around the globe as the business day begins in each financial center, first to Tokyo, London, and New York. Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur - day or night.

The FX market is considered an Over The Counter (OTC) or 'interbank' market, due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. Trading is not centralized on an exchange, as with the stock and futures markets.

Understanding Forex Quotes

Reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1.

The US dollar is the centerpiece of the Forex market and is normally considered the 'base' currency for quotes. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 120.01 means that one U.S. dollar is equal to 120.01 Japanese yen.

When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before.

The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.

In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.

In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.

Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.

When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'offer'. The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency). The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency).

Forex Vs. Equities

If you are interested in trading currencies online, you will find that the Forex market offers several advantages over equities trading.

24-Hour Trading

Forex is a true 24-hour market, which offers a major advantage over equities trading. Whether it's 6pm or 6am, somewhere in the world there are always buyers and sellers actively trading foreign currencies. Traders can always respond to breaking news immediately, and P&L is not affected by after hours earning reports or analyst conference calls.

After hours trading for U.S. equities brings with it several limitations. ECN's (Electronic Communication Networks), also called matching systems, exist to bring together buyers and sellers - when possible. However, there is no guarantee that every trade will be executed, nor at a fair market price. Quite frequently, traders must wait until the market opens the following day in order to receive a tighter spread.

Superior Liquidity

With a daily trading volume that is 50x larger than the New York Stock Exchange, there are always broker/dealers willing to buy or sell currencies in the FX markets. The liquidity of this market, especially that of the major currencies, helps ensure price stability. Traders can almost always open or close a position at a fair market price.

Because of the lower trade volume, investors in the stock market are more vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transaction.

100:1 Leverage

100:1 leverage is commonly available from online FX dealers, which substantially exceeds the common 2:1 margin offered by equity brokers. At 100:1, traders post $1000 margin for a $100,000 position, or 1%.

While certainly not for everyone, the substantial leverage available from online currency trading firms is a powerful, moneymaking tool. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.

The most effective way to manage the risk associated with margined trading is to diligently follow a disciplined trading style that consistently utilizes stop and limit orders. Devise and adhere to a system where your controls kick in when emotion might otherwise take over.

Lower Transaction Costs

It is much more cost-efficient to trade Forex in terms of both commissions and transaction fees. FOREX.com charges NO commissions or fees whatsoever, while still offering traders access to all relevant market information and trading tools. In contrast, commissions for stock trades range from $7.95-$29.95 per trade with online discount brokers up to $100 or more per trade with full service brokers.

Another important point to consider is the width of the bid/ask spread. Regardless of deal size, forex dealing spreads are normally 5 pips or less (a pip is .0005 US cents).** In general, the width of the spread in a forex transaction is less than 1/10 that of a stock transaction, which could include a .125 (1/8) wide spread.

Trading Potential In Both Rising And Falling Markets

In every open FX position, an investor is long in one currency and short the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a rising as well as a falling market.

The ability to sell currencies without any limitations is another distinct advantage over equity trading. In the US equity markets, it is much more difficult to establish a short position due to the Zero Uptick rule, which prevents investors from shorting a stock unless the immediately preceding trade was equal to or lower than the price of the short sale.

Forex Vs. Futures

The global foreign exchange market is the largest, most active market in the world. Trading in the forex markets takes place nearly round the clock with over $1 trillion changing hands every day. It is the main event.

The benefits of forex over currency futures trading are considerable. The dissimilarities between the two instruments range from philosophical realities such as the history of each, their target audience, and their relevance in the modern forex markets, to more tangible issues such as transactions fees, margin requirements, access to liquidity, ease of use and the technical and educational support offered by providers of each service. These differences are outlined below:

• More Volume = Better Liquidity. Daily currency futures volume on the CME is just 1% of the volume seen every day in the forex markets. Incomparable liquidity is one of many advantages that forex markets hold over currency futures. Truth be told, this is old news. Any currency professional can tell you that cash has been king since the dawn of the modern currency markets in the early 1970's. The real news is that individual traders from every risk profile now have full access to the opportunities available in the forex markets.

• Forex markets offer tighter bid to offer spreads than currency futures markets. By inverting the futures price to compare it to cash, you can readily see that in the USD/CHF example above, inverting the futures dealing price of .5894 - .5897 results in a cash price of 1.6958 - 1.6966, 8 pips vs. the 5-pip spread available in the cash markets.

• Forex markets offer higher leverage and lower margin rates than those found in currency futures trading. When trading currency futures, traders have one margin rate for "day" trades and another for "overnight" positions. These margin rates can vary depending on transaction size. FOREX.com currency trading gives the customer one rate all the time, day and night.

• Forex markets utilize easily understood and universally used terms and price quotes. Currency futures quotes are inversions of the cash price. For example, if the cash price for USD/CHF is 1.7100/1.7105, the futures equivalent is .5894/ .5897; a methodology followed only in the confines of futures trading. Currency futures prices have the added complication of including a forward forex component that takes into account a time factor, interest rates and the interest differentials between various currencies. The forex markets require no such adjustments, mathematical manipulation or consideration for the interest rate component of futures contracts.

• Forex trades executed through FOREX.com are commission free. Currency futures have the added baggage of trading commissions, exchange fees and clearing fees. These fees can add up quickly and seriously eat into a trader's profits.

In contrast, currency futures are a small part of a much larger market; one that has undergone historical changes over the last decade.

• Currency futures contracts (called IMM contracts or international monetary market futures) were created at the Chicago Mercantile Exchange in 1972.

• These contracts were created for the market professionals, who at that time, accounted for 99% of the volume generated in the currency markets.

• While some intrepid individuals did speculate in currency futures, highly trained specialists dominated the pits.

• Rather than becoming a hub for global currency transactions, currency futures became more of a sideshow (relative to the cash markets) for hedgers and arbitragers on the prowl for small, momentary anomalies between cash and futures currency prices.

• In what appears to be a permanent rather than cyclical change, fewer and fewer of these arbitrage windows are opening these days. And, when they do, they are immediately slammed shut by a swarm of professional dealers.

These changes have significantly reduced the number of currency futures professionals, closed the window further on forex vs. futures arbitrage opportunities and so far, have paved the way to more orderly markets. And while a more level playing field is poison to the P&L of a currency futures trader, it's been the pathway out of the maze for individuals trading in the forex markets.

Forex 1-2-3 Method

This particular technique has been around for a long time and I first saw it used in the futures market. Since then I have seen traders using it on just about every market and when applied well, can give amazingly accurate entry levels.

 

 
Lets first start with the basic concept. During the course of any trend, either up or down, the market will form little peaks and valleys. see the chart below:

The problem is, how do you know when to enter the market and where do you get out. This is where the 1-2-3 method comes in. First let's look at a typical 1-2-3 set up:

Nice and simple, but it still doesn't tell us if we should take the trade. For this we add an indictor. You could use just about any indictor with this method but my preferred indictor is MACD with the standard settings of 12,26,9. With the indictor added, it now looks like this:

 

 

Now here is where it gets interesting. The rules for the trade are as follows:

Uptrend

1. This works best as a reversal pattern so identify a previous downtrend

2. Wait for the MACD to signal a buy and for the 1-2-3 set up to be in place.

3. As the market pulls back to point 3, the MACD should remain in buy mode or just slightly dip into sell.

4. Place a buy entry order 1 pip above point 2

5. Place a stop loss order 1 pip below point 3

6. Measure the distance between point 2 and 3 and project that forward for your exit.

7. Point 2, should not be lower than point 1

The reverse is true for short trades. As the market progresses you can trail your stop to 1 pip below the most recent low (Valley in an uptrend). You can also use a break in a trend line as an exit.

Some examples:

There are a lot of variations on the 1-2-3 setup but the basic concept is always the same. Try experimenting with it on your favorite time frame.

Main Players In Forex

Central Banks And Governments

Policies that are implemented by governments and central banks can play a major roll in the FX market. Central banks can play an important part in controlling the country's money supply to insure financial stability. 

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Banks

A large part of FX turnover is from banks. Large banks can literally trade billions of dollars daily. This can take the form of a service to their customers or they themselves speculate on the FX market.

Hedge Funds

As we know the FX market can be extremely liquid which is why it can be desirable to trade. Hedge Funds have increasingly allocated portions of their portfolios to speculate on the FX market. Another advantage Hedge Funds can utilize is a much higher degree of leverage than would typically be found in the equity markets.

Corporate Businesses

The FX market mainstay is that of international trade. Many companies have to import or exports goods to different countries all around the world. Payment for these goods and services may be made and received in different currencies. Many billions of dollars are exchanges daily to facilitate trade. The timing of those transactions can dramatically affect a company's balance sheet.

The Man In The Street

Although you may not think it, the man in the street also plays a part in toady's FX world. Every time he goes on holiday overseas he normally need to purchase that country's currency and again change it back into his own currency once he returns. Unwittingly he is in fact trading currencies.

He may also purchase goods and services whilst overseas and his credit card company has to convert those sales back into his base currency in order to charge him.

Speculators And Investors

We shall differentiate speculator from investors here with the definition that an investor has a much longer time horizon in which he expects his investment to yield a profit. Regardless of the difference both speculators and investors will approach the FX market to exploit the movement in currency pairs.

They both will have their reason for believing a particular currency will perform better or worse as the case may be and will buy or sell accordingly. They may decide that the Euro will appreciate against the US Dollar and take what is called a long position in Euro. If the Euro does in fact gain ground against the US Dollar they will have made a profit.

Accounts In Forex

Although the movement today is towards all transaction eventually finishing in a profit and loss in US Dollars it is important to realize that your profit or loss may not actually be in US Dollars.

From my observation the trend is more pronounced in the US as you would expect. Most US based traders assume they will see their balance at the end of each day in US Dollars. I have even spoken with some traders who are oblivious to the fact the their profit might have actually been in Japanese Yen.

Let me explain a little more. You sell (go short) USD/JPY and as such are short USD and Long (bought) JPY. You enter the trade at 116.10 and exit 116.90. You in fact made 80,000 Japanese Yen (1 lot traded) not US Dollars.

If you traded all four major currencies against the US Dollar you would in fact have made or lose in EUR, GPY, JPY and CHF. This might give you a ledger balance at the end of the day or month with four different currencies.

This is common in London. They will stay in that currency until you instruct the broker to exchange the currencies into your own base currency.

This actually happened to me. After dealing with mainly US based brokers it had never occurred to me that my statement would be in anything other than US Dollars.

This can work for you or against you depending on the rate of exchange when you change back into your home currency. Once I knew the convention I simply instructed the broker to change my profit or loss into US Dollars when I closed my position. It is worth checking how your broker approaches this and simply ask them how they handle it. A small point, but worth noting.

Nowadays most countries have regulated forex, but it is still worth checking that the broker who you are dealing with is regulated in the country that it operates, insured or bonded and has some kind of track recorded.

I cannot advise you on which broker you should use as there are just to many variables to each person, but as a rule of thumb, nearly all countries have some kind of regulatory authority who will be able to advise you. Most of the regulatory authorities will have a list of brokers that fall within their jurisdiction and will give you that list. They probably wont tell whom to use but at least if the list came from them you can have some confidence in those companies.

Once you have a list, give a few of them a call, see who you feel comfortable with, ask for them to send you their polices and procedures. If you live near where your broker is based, go spend the day with him. I have been to many brokerages just to check them out. It will give you a chance to see their operation and meet their team.

This brings up another interesting point. When you open an account with a broker you will have to fill in some forms basically stating your acceptance of their polices. This can range from a 1 page document to something resembling a book. Take the time to read through these documents and make a list of things you don't understand or want explained.

Most reputable companies will be happy to spend some time with you on this. Your involvement with your broker is largely up to you. As a forex trader you will probably spend long hours staring at the screen without talking to anyone. You may be the sort of person who likes this or you may be the sort of person who likes to chat with the dealer in the trading room. You will normally get a call once a week or once a month from someone in the brokerage asking if everything is OK.

Rollovers In Forex

Even though the mighty US dominates many markets, most of Spot Forex is still traded through London in Great Britain. So for our next description we shall use London time. Most deals in Forex are done as Spot deals. Spot deals are nearly always due for settlement two business days later. This is referred to as the value date or delivery date. On that date the counter parties theoretically take delivery of the currency they have sold or bought.

In Spot FX the majority of the time the end of the business day is 21:59 (London time). Any positions still open at this time are automatically rolled over to the next business day, which again finishes at 21:59.

This is necessary to avoid the actual delivery of the currency. As Spot FX is predominantly speculative most of the time the trades never wish to actually take delivery of the currency. They will instruct the brokerage to always rollover their position.

Many of the brokers nowadays do this automatically and it will be in their polices and procedures. The act of rolling the currency pair over is known as tom.next, which stands for tomorrow and the next day.

Just to go over this again, your broker will automatically rollover your position unless you instruct him that you actually want delivery of the currency. Another point noting is that most leveraged accounts are unable to actual deliver of the currency as there is insufficient capital there to cover the transaction.

Remember that if you are trading on margin, you have in effect got a loan from your broker for the amount you are trading. If you had a 1 lot position you broker has advanced you the $100,000 even though you did not actually have $100,000. The broker will normally charge you the interest differential between the two currencies if you rollover your position. This normally only happens if you have rolled over the position and not if you open and close the position within the same business day.

To calculate the broker's interest he will normally close your position at the end of the business day and again reopen a new position almost simultaneously. You open a 1 lot ($100,000) EUR/USD position on Monday 15th at 11:00 at an exchange rate of 0.9950.

During the day the rate fluctuates and at 22:00 the rate is 0.9975. The broker closes your position and reopens a new position with a different value date. The new position was opened at 0.9976 - a 1 pip difference. The 1 pip deference reflects the difference in interest rates between the US Dollar and the Euro.

In our example your are long Euro and short US Dollar. As the US Dollar in the example has a higher interest rate than the Euro you pay the premium of 1 pip.

Now the good news. If you had the reverse position and you were short Euros and long US Dollars you would gain the interest differential of 1 pip. If the first named currency has an overnight interest rate lower than the second currency then you will pay that interest differential if you bought that currency. If the first named currency has a higher interest rate than the second currency then you will gain the interest differential.

To simplify the above. If you are long (bought) a particular currency and that currency has a higher overnight interest rate you will gain. If you are short (sold) the currency with a higher overnight interest rate then you will lose the difference.

I would like to emphasis here that although we are going a little in-depth to explain how all this works, your broker will calculate all this for you. The purpose of this book is just to give you an overview of how the forex market works.

Leverage in Forex

Leverage financed with credit, such as that purchased on a margin account is very common in Forex. A margined account is a leverageable account in which Forex can be purchased for a combination of cash or collateral depending what your brokers will accept.

The loan (leverage) in the margined account is collateralized by your initial margin (deposit), if the value of the trade (position) drops sufficiently, the broker will ask you to either put in more cash, or sell a portion of your position or even close your position.

Margin rules may be regulated in some countries, but margin requirements and interest vary among broker/dealers so always check with the company you are dealing with to ensure you understand their policy.

Up until this point you are probably wondering how a small investor can trade such large amounts of money (positions). The amount of leverage you use will depend on your broker and what you feel comfortable with. There was a time when it was difficult to find companies prepared to offer margined accounts but nowadays you can get leverage from a high as 1% with some brokers. This means you could control $100,000 with only $1,000.

 

 

Typically the broker will have a minimum account size also known as account margin or initial margin e.g. $10,000. Once you have deposited your money you will then be able to trade. The broker will also stipulate how much they require per position (lot) traded.

In the example above for every $1,000 you have you can take a lot of $100,000 so if you have $5,000 they may allow you to trade up to $500,00 of forex.

The minimum security (Margin) for each lot will very from broker to broker. In the example above the broker required a one percent margin. This means that for every $100,000 traded the broker wanted $1,000 as security on the position.

Margin call is also something that you will have to be aware of. If for any reason the broker thinks that your position is in danger e.g. you have a position of $100,000 with a margin of one percent ($1,000) and your losses are approaching your margin ($1,000). He will call you and either ask you to deposit more money, or close your position to limit your risk and his risk.

If you are going to trade on a margin account it is imperative that you talk with your broker first to find out what their polices are on this type of accounts.

Variation Margin is also very important. Variation margin is the amount of profit or loss your account is showing on open positions.

Let's say you have just deposited $10,000 with your broker. You take 5 lots of USD/JPY, which is $500,000. To secure this the broker needs $5,000 (1%).

The trade goes bad and your losses equal $5001, your broker may do a margin call. The reason he may do a margin call is that even though you still have $4,999 in your account the broker needs that as security and allowing you to use it could endanger yourself and him.

Another way to look at it is this, if you have an account of $10,000 and you have a 1 lot ($100,000) position. That's $1,000 assuming a (1% margin) is no longer available for you to trade. The money still belongs to you but for the time you are margined the broker needs that as security.

Another point of note is that some brokers may require a higher margin during the weekends. This may take the form of 1% margin during the week and if you intend to hold the position over the weekend it may rise to 2% or higher. Also in the example we have used a 1% margin. This is by no means standard. I have seen as high as 0.5% and many between 3%-5% margin. It all depends on your broker.

There have been many discussions on the topic of margin and some argue that too much margin is dangerous. This is a point for the individual concerned. The important thing to remember as with all trading is that you thoroughly understand your broker's policies on the subject and you are comfortable with and understand your risk.