Forex Trading Basics

Forex Trading Basics

What is Forex

  • The forex market (foreign exchange market or currency market) is a global decentralized market for currency trading.
  • The forex market determines the relative values of currencies.
  • In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for some quantity of another currency.

Market size and liquidity

Largest and most liquid financial market in the world. (volume of trading)

  • According to the Bank for International Settlements
    • In 1998, average daily turnover was 1.7 trillion.
    • As of April 2007 daily volume was 3.21 trillion.
    • As of April 2010, average daily turnover was estimated at $3.98 trillion,
      • $1.490 trillion in spot transactions
      • $475 billion in outright forwards
      • $1.765 trillion in foreign exchange swaps
      • $43 billion currency swaps
      • $207 billion in options and other products
    • Trading in forex markets averaged $5.3 trillion per day in April 2013.(Foreign exchange swaps, $2.2 trillion per day; spot trading $2.0 trillion per day in April 2013)

Foreign exchange trading volume by country

  • Rank in 2010: UK(36.7%),US(17.9%),Japan(6.2%)
  • Rank in 2013: UK(41%), US(19%),Singapore(5.7%),Japan(5.6%),Hong Kong(4.1%)
  • Currently The biggest geographic trading center is UK, primarily London.

Trading characteristics

Uniqueness of forex market

  • 24 hours continuous operation except weekends,from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
  • Geographical dispersion;
  • The use of leverage
  • The low margins of relative profit
  • Largest asset class in the world with huge trading volume, high liquidity;
  • The market closest to the ideal of perfect competition
  • An over-the-counter market where brokers/dealers negotiate directly with one another
  • No central exchange or clearing house.
  • very little cross-border regulation.
  • Major news that affect the exchange rates is released publicly(often on scheduled dates). Traders receive the same news at the same time.

Forex spot market & futures market

  • Forex spot market or forex cash market means the exchange rate right now. The trade occurs immediately, on the spot. Suppose you want to buy some foods, the store owner give you foods, right now , on the spot.
  • Futures market means the exchange rate in the future. Suppose you only need foods next week(future), you enter into a contract with the store owner to deliver foods to you in the future at a specified price.

Market participants

Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail traders. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004)

Forex market have several levels depend on the amount of money traded. The higher the level, the lower the spreads(bid ask difference). At The top level is the interbank market(which consists of largest commercial banks and securities dealers, and accounts for 39% of all transactions in 2010). At the relatively lower level are smaller banks, large multi-national corporations , large hedge funds, and some retail market makers. Retail traders are at the lowest level.

National Central banks

  • Have substantial foreign exchange reserves to stabilize the market.
  • Have target rates for their currencies.
  • Will try to control the money supply, inflation, interest rates.
  • Often, the rumor of a central bank foreign exchange intervention might be enough to stabilize a currency. Aggressive intervention might be used when needed.
  • The effectiveness of their intervention is uncertain. The market can easily overwhelm any central bank.

Commercial companies.

  • Commercial companies and multinational corporations need foreign exchange to pay for goods or services.
  • Multinational corporations also need to hedge risk and pay employees in different countries.

Hedge funds as speculators

Hedge funds have a reputation for aggressive currency speculation. They control and borrow billions of dollars, which may overwhelm intervention by central banks.

Investment management firms

For example, an investment manager having an international equity portfolio might need foreign currencies to pay for foreign securities purchases. Some investment management firms also speculate in the forex market.

Non-bank foreign exchange companies

They offer currency exchange and international payments to private individuals and companies. (They do not offer speculative trading services).

Money transfer/remittance companies and bureaux de change

  • Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country.
  • Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers.

Retail foreign exchange traders

Individual investors participate indirectly through retail forex brokers or banks.

Currency Pair

  • Currencies are traded in pairs. Each currency pair constitutes an individual trading product.
  • Every currency trade involves at least two different currencies. If someone is short USD, then that person must be long some other currencies at the same time. He/she can't trade only one currency because one currency alone does not fluctuate.
  • The value of a currency fluctuates constantly when measured against other currencies. The exchange rate of a currency pair is what forex traders trade with.
  • The first currency of any currency pair is called the base currency. The second member of any currency pair is called the counter currency or quote currency.
  • In the spot currency market, the order of the currencies in a currency pair is fixed. The ISO (International Organization for Standardization) determines the symbol for a currency and the order of currencies in each pair. For example, EUR/USD is the official order determined by the ISO.
    • Usually, USD is the base currency (e.g. USDJPY, USDCAD, USDCHF).
    • The exceptions are GBP, AUD, NZD and EUR where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).
  • The quotation EUR/USD 1.2366 means 1 EUR = 1.2366 USD, so:
    • If the EUR/USD quote changes from 1.2366 to 1.2376, EUR has increased in relative value(either USD has weakened or EUR has strengthened, or both)
    • If the EUR/USD quote changes from 1.2366 to 1.2350, EUR has decreased in relative value(either USD has strengthened or EUR has weakened, or both)
  • The factors affecting the currency XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.
  • The most traded pairs are called the Majors(EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF, NZD/USD and USD/CAD). They constitute the largest share of forex market and have high liquidity.
  • Widely Traded Currency Pairs(created from the eight major currencies (USD, EUR, GBP, JPY, CHF, CAD, AUD, NZD)
    SymbolDescription
    EUR/USDEuro/U.S. Dollar
    GBP/USDBritish Pound/U.S. Dollar
    USD/JPYU.S. Dollar/Japanese Yen
    USD/CHFU.S. Dollar/Swiss Franc
    EUR/JPYEuro/Japanese Yen
    EUR/GBPEuro/British Pound
    EUR/CHFEuro/Swiss Franc
    GBP/JPYBritish Pound/Japanese Yen
    GBP/CHFBritish Pound/Swiss Franc
    NZD/USDNew Zealand Dollar/U.S. Dollar
    AUD/USDAustralian Dollar/U.S. Dollar
    USD/CADU.S. Dollar/Canadian Dollar
    AUD/JPYAustralian Dollar/Japanese Yen
    NZD/JPYNew Zealand Dollar/Japanese Yen
  • Less Widely Traded Currency Pairs
    SymbolDescription
    EUR/DKKEuro/Danish Krone
    USD/SEKU.S. Dollar/Swedish Krone
    USD/SGDU.S. Dollar/Singapore Dollar
    EUR/RUBEuro/Russian Ruble
    EUR/SEKEuro/Swedish Krone
    CAD/CHFCanadian Dollar/Swiss Franc
    NZD/CADNew Zealand Dollar/Canadian Dollar
    USD/HKDU.S. Dollar/Hong Kong Dollar
    USD/CNYU.S. Dollar/Chinese Yuan
    USD/DKKU.S. Dollar/Danish Krone
    USD/BRLU.S. Dollar/Brazilian Real
    USD/MXNU.S. Dollar/Mexican Peso
    USD/RUBU.S. Dollar/Russian Ruble
    GBP/NZDBritish Pound/New Zealand Dollar
  • Major Currencies, Corresponding Central Banks & Nicknames
    CurrencySymbolCentral Banknickname
    EuroEUREuropean Central Bank, ECBSingle Currency
    U.S. DollarUSDFederal Reserve, FedGreenback, Buck
    Swiss FrancCHFSwiss National Bank, SNBSwissy, Chef
    Japanese YenJPYBank of Japan, BoJYen
    British PoundGBPBank of England, BoESterling
    Canadian DollarCADBank of Canada, BoCLoonie
    Australian DollarAUDReserve Bank of Australia, RBAAussie
    New Zealand DollarNZDReserve Bank of New Zealand, RBNZKiwi
  • Less Widely Traded Currencies. Don't ignore these currencies, sometimes there are great opportunities.

The chart track the base currency

The direction of the exchange rate is based on the base currency. If the base currency is gaining vs. the quote or counter currency, the chart will moving up,vice versa. The chart below illustrates the EUR/USD currency pair.

The Chart Track The base currency

  • left side: The exchange rate is moving higher. This means that EUR (base currency) is rising vs. USD or USD (counter currency) is falling vs. EUR.
  • right side: The exchange rate is moving lower. This means that EUR (base currency) is falling vs. USD or USD (counter currency) is rising vs. EUR.

Lot size

Currencies are traded in fixed contract sizes(lot sizes). One lot is the unit of measurement (in terms of size) for a currency pair.

  • One Standard Lot = 100,000 Units of the Base Currency
  • One Mini Lot = 10,000 Units of Currency
  • One Micro Lot = 1,000 Units of Currency
  • One Nano Lot = 100 Units of Currency

Pip value

One pip is the unit of measurement (in terms of price or value) for a currency pair.

  • One pip EUR/USD (Standard Account) = $10 USD
  • One pip EUR/USD (Mini Account) = $1 USD
  • One pip EUR/USD (Micro Account) = 10 cents USD
  • One pip EUR/USD (Nano Account) = 1 cent USD

Pip calculation

The value of a pip is determined by the counter or quote currency(the second member of the currency pair), and has a fixed value in that currency. For example:

The value of 1 pip of EUR/USD:

  • In a standard account: EUR/USD pip = 0.0001 × 100,000 = USD $10.00 per pip
  • In a mini account: EUR/USD pip = 0.0001 × 10,000 = USD $1.00 per pip
  • In a micro account: EUR/USD pip = 0.0001 × 1,000 = USD $0.10 per pip
  • In a nano account: EUR/USD pip = 0.0001 × 100 = USD $0.01 per pip

The value of 1 pip of USD/CHF

  • In a standard account: USD/CHF pip = 0.0001 × 100,000 = CHF 10.00 per pip (One pip of USD/CHF is worth 10 CHF)
  • In a mini account: USD/CHF pip = 0.0001 × 10,000 = CHF 1.00 per pip
  • In a micro account: USD/CHF pip = 0.0001 × 1,000 = CHF 0.10 per pip
  • In a nano account: USD/CHF pip = 0.0001 × 100 = CHF 0.01 per pip

First currency = 1 Think of base currency as the number 1. For example, if the quote for EUR/USD is 1.5675, it means that 1 euro equals 1.5675 U.S. dollars.

  • If EUR/CHF exchange rate is 1.4000, then 1 EUR = 1.4 CHF
  • If GBP/USD exchange rate is 1.6160, then 1 GBP = 1.616 USD
  • If AUD/NZD exchange rate is 1.3650, then 1 AUD = 1.365 NZD
  • If USD/JPY exchange rate is 107.90, then 1 USD = 107.9 JPY

The pip value of USD/CHF fluctuates when it is calculated in terms of the base currency (the first member of the currency pair). For example,

  • One pip of USD/CHF is worth 10 CHF (fixed value)
  • If the USD/CHF exchange rate is 1.1400, then 1 USD=1.1400 CHF. 10 CHF= 10 divided by 1.1400 = $8.771 USD. One pip of USD/CHF is worth $8.771 USD.
  • If the USD/CHF exchange rate is 1.1100, then 1 USD=1.1100 CHF. 10CHF= 10 divided by 1.1100 = $9.009 USD. One pip of USD/CHF is worth $9.009 USD

Position: Long, Short, Flat

Long = a position that will benefit if the exchange rate rises Short = a position that will benefit if the exchange rate falls Flat = absence of a long or short position

Position vs Trade Your current position(long, short, or flat) is the result of the trades you have placed. For example,suppose you place a trade to buy 5 lots of EUR/USD, and 30 minutes later, you place another trade to buy 2 lots of EUR/USD. In this case, you had 2 trades, and a long position of 7 lots of EUR/USD.

Long and Short vs Buy and Sell

  • Long and short are more precise than buy and sell.
    • Long only means a position that will benefit if the exchange rate rises
    • Short only means a position that will benefit if the exchange rate falls

Buy can mean different things. Suppose you want to buy EUR/USD.This could mean

  • You want to open a long position because you think the EUR/USD will move higher.
  • You've short EUR/USD and you're buying to close that position.

Sell can mean different things. Suppose you want to sell EUR/USD.This could mean

  • You want to open a short position because you think the EUR/USD will move lower.
  • You've long EUR/USD and you're selling to close that position.

Long one, short the other

When a Forex trader long a currency pair, he/she is long the base currency and short counter or quote currency:

  • Long USD/CAD -> long the USD and short the CAD
  • Long NZD/USD -> long the NZD and short the USD
  • Long EUR/USD -> long the EUR and short the USD

Conversely, when a trader shorts a currency pair, he/she is short the base currency and long the counter or quote currency:

  • Short USD/CHF -> short the USD and long the CHF
  • Short GBP/CHF -> short the GBP and long the CHF
  • Short AUD/JPY -> short the AUD and long the JPY

As traders, we usually think of each currency pair as a single unit, just like a stock.For example, When we believe the price of a currency pair or a stock is going to rise, we would open a long position, vice versa.

In fact, we are trading the exchange rate between currencies because an individual currency can not rise and fall, it can only fluctuates in relation to other currencies. We often call the exchange rate the price of the currency pair.

Margin Requirement and Leverage

Margin: the deposit that's required to open or maintain a position.

  • Used margin: the amount that's being used to maintain or open a position
  • Usable margin: the amount available to open new positions or add to existing positions

Leverage. e.g. 100:1 leverage. With a $1,000 margin balance in your account and a 1 percent margin requirement, you can buy or sell a position worth $100,000.

Note that most forex brokers will close all open trades automatically when the margin balance falls below the amount required to keep the positions open. If not, traders might lose more than the money they have in their account because of leverage.

Leave a Reply

Your email address will not be published.

 
 

2 thoughts on “Forex Trading Basics

  1. Dr. HL. Abdul Fattah Ak CA says:

    Good

    Did you find this review helpful? Yes   No

    • Dr. HL. Abdul Fattah Ak CA says:

      Yes very helful

      Did you find this review helpful? Yes   No