Basics
What is Forex Trading Forex and how does it work?
Intoduction
Forex or Foreign Exchange is the simultaneous buying of one currency and the selling of another. Currencies are traded in pairs. The Forex Market has more buyers and sellers and daily volume than any other market in the world and takes place in major financial institutions across the globe. The forex market is open 24 hours a day five days a week.
Buying/Selling
In the forex market, currencies are always priced in pairs and all trades result in the simultaneous buying of one currency and the selling of another. The objective of currency trading is to buy the currency that increases in value relative to the one you sold. If you have bought a currency and the price appreciates in value, then you must sell the currency back in order to lock in the profit.
Quoting Conventions
Currencies are quoted in pairs. The first listed currency is known as the base currency and the second is called the counter or quote currency.
Currencies are quoted using five significant numbers, with the last placeholder called a point or a pip
For example a EUR/USD quote 1.1345/1.1350
Like all financial products, forex quotes include a “bid” and “ask” or a —sell“ and a —buy“ price. By quoting both the bid and ask in real time, brokers ensure that traders always receive a fair price on all transactions. As in any traded instrument, there is an immediate cost in establishing a position. This cost will vary between the different brokers and is sometimes called —spread“.
For example, USD/JPY may bid at 131.40 and ask at 131.45, this five-pip spread defines the trader‘s cost, which can be recovered with a favourable currency move in the market.
Margin
The margin is a performance bond, or good faith deposit, to ensure against the total loss of your account. Trade stations have margin management capabilities. In the event that funds in the account fall below margin requirements, the broker‘s dealing desk will close all open positions. This prevents clients’ accounts from falling into a negative balance, even in a
highly volatile, fast moving market.
The new NFA rule requires a minimum 1% margin at all time to maintain an open trade. (Note this may change from time to time so although we use 1% as the example at some stage in the future the margin maybe different. However using similar calculations one can easily calculate the new margins) Some deal stations automatically calculate this according to the
formula and hence the margin requirements are continually varying.
Based on a 1% margin requirement
Example 1: GBP/USD
rate: 1.7442/1.7447
account type: 100 000/lot account
1% leverage: 100 000×0.01 (1%) =1000units
When you are long (buy) GBP/USD, the margin required is:
1.7447 (GBP/USD) x1000 (units of base currency GBP) = USD1744 for each lot.
Some brokers require $1,800 margin for GBP pairs.
Example 2: EUR/USD
rate: 1.2326/1.2331
account type: 100 000/lot account
1% leverage: 100 000×0.01 (1%) =1000units
When you are long (buy) EUR/USD, the margin required is:
1.2331 (EUR/USD) x1000 (units of base currency EUR) = USD1233 for each lot.
Some brokers require $1,300 per lot in margin for EUR based pairs. In general, a margin of $1,300 allows you to control a $100,000 spot currency position. This is an efficient use of trading capital as the leverage in futures and stock markets is much less.
Example 3: Where the USD is the BASE currency, the margin requirement is
USD1000
(ie 1% of 100 000)
When you are long (buy) USD/CAD, USD/CHF etc the margin required is: =
USD1000 for each lot.
Forex Market and Locations
The forex market is a seamless 24 hour market and is open 5 days a week. At 5 pm Sunday, New York time, trading begins as markets open in Sydney and Singapore. At 7 pm the Tokyo market opens, followed by London at 2 am and finally New York at 8 am. (Time is based on New York time) As a trader, this allows you to react to favourable/unfavourable news by trading
immediately. The trading of forex takes place all over the world and is not located in any one central location. Deals are done between a variety of traders, from banks to managed funds to individual traders
Size of the Forex Market
Forex trades approximately US$1.85 trillion a day and is by far the most liquid market in the world. It takes the NY Stock Exchange THREE MONTHS to trade the same USD value as the forex trades each and every day making it the largest and most liquid market in the world. This market can absorb trading volume and transaction sizes that dwarf the capacity of any other
market. If you compare this to the US$30 billion per day futures market, it becomes clear that the futures markets provide only limited liquidity. The forex market is always liquid, meaning positions can be liquidated and stop orders executed without slippage.
Brokers and Market Makers
Market Maker – One that consistently makes two way prices, providing both a bid and an offer. Unlike brokers, market makers trade their capital
Broker – An individual who matches buy and sell orders in return for a commission. The bid and offer prices are those of the market participants and not of the broker.
Currency Pairs
Traders can trade a variety of currency pairs, limited only by which pairs each broker provides. Major currency pairs are typically the USD pairs for example
EURUSD GBPUSD AUDUSD USDJPY USDCHF
Cross currency pairs are pairs which do not involve the USD for example
EURGBP EURJPY GBPJPY EURCHF
EUR= Euro, GBP= Pound, CHF= Swiss Franc, JPY=Yen, AUD= Aussie $
Point/Pip Values
Point/Pip values is the US$ value for each Point/Pip (these are typical values and can vary between the different Brokers and Market Makers)
Regular Mini
Euro = $10 ($1)
Pound= $10 ($1)
Australian Dollar= $10 ($1)
Swiss Franc CHF= $7.60 ($0.76)
Canadian Dollar CAD= $7.30 ($0.73)
Japanese Yen = $8.45 ($0.85)
Major Market Participants
Traders include Governments, Reserve Banks, Large Mutual Funds, Banks,
Companies, Hedge Funds, Individual Traders.
Fundamental or Technical
The two basic approaches to analysing the currency market are Fundamental
Analysis and Technical Analysis. The fundamental analyst concentrates on
the underlying causes of price movements, while the technical analyst
studies the price movements themselves.
Fundamental Analysis
Fundamental analysis focuses on the
economic
social
political
geopolitical forces
These drive supply and demand.
Fundamental analysts look at various macroeconomic indicators such as
economic growth rates,
interest rates,
inflation,
unemployment, etc.
However, there is no single set of beliefs that guide fundamental analysis. There are several theories as to how currencies should be valued. Do not try and analyse the fundamentals unless you are a financial expert. Let the experts do this and follow their lead by reading the charts. Be aware when announcements are due. Sometimes the experts are wrong and get caught by unpredictable actions.
Technical Analysis
Technical analysis focuses on the study of price movements. Historical
currency data is used to forecast the direction of future prices. The premise of technical analysis is that all current market information is already reflected in the price of that currency, therefore, studying price action is all that is required to make informed trading decisions.
The primary tools of the technical analyst are charts. Charts are used to identify trends and patterns in order to find profit opportunities. The most basic concept of technical analysis is that markets have a tendency to trend. Being able to identify trends in their earliest stage of development is the key to technical analysis.