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Introduction to FOREX
Foreign Exchange trading (also
called Forex, FX, or currency trading) describes trading in the
many currencies of the world. It is the largest and least
regulated market providing the greatest liquidity to investors.
Daily volume in the currency markets is around $1.5 trillion. By
comparison, the NYSE daily volume averages $25 billion a day.
The spot Forex market is the most liquid. Spot, meaning that
trades are settled within two banking days. There is no central
exchange of physical location. Trading takes place
over-the-counter, 24-hours a day directly between the two
parties of a trade over the telephone and electronically.
Participants in Forex include central banks, corporations,
individual investors and speculators, and hedge funds. With the
advent of electronic trading platforms, self-directed investors
and smaller financial firms now have access to the same
liquidity as larger market participants.
Trading, or speculation, makes up 95% of the daily volume. The
other 5% of daily volume consists of governments and commercial
companies converting one currency into another from buying and
selling goods and services.
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Foreign Exchange trading, better
known as Forex trading, is the concurrent buying of one currency
while selling another. Forex trading is based on the movements
of a set of currencies that are sold in currency pairs, where
one currency is the base and one is the counter or quote
currency. It also puts the currencies in terms of one currency's
supply compared to the other currency's demand. The gains or
loss on a trade are based on the relative movements of the
currencies within each currency pair. Pips or points are the
numerical way in which the movements of currencies are quoted,
positive movements being gains, negative movements reflecting
losses. There are countless tools, and strategies associated
with currency trading, and when first beginning, it is important
to understand these tools before implementing any of them in
trading strategies.
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Most Commonly Traded
Currencies
US Dollar (USD)
Japanese Yen (JPY)
Euro (EUR)
British Pound (GBP)
Canadian Dollar (CAD)
Australian Dollar (AUD)
Swiss Franc (CHF)
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Commonly Traded Currency Pairs
US Dollar and the Japanese Yen (USD/JPY)
Euro and US Dollar (EUR/USD)
US Dollar and Swiss franc (USD/CHF)
British Pound and US Dollar (GBP/USD)
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Forex Quote
When quoting currency pairs, the first currency is referred to
as the base currency and the second, the counter or quote
currency. The base currency is always equal to 1 monetary unit
of exchange, for example, 1 Dollar, 1 Pound, 1 Euro. The
dominant base currencies are, in order of frequency, the EUR,
GBP, and USD. When a currency is quoted against the US Dollar it
is called a direct rate. Any currency not against the US Dollar
is referred to as a cross rate.
The quote currency is translated into a certain number of units
of the base currency. For example, a quote of USD/JPY at 1.20,
says that for every 1 US Dollar, you get 1.20 Japanese Yen,
while a quote for AUD/JPY of 67.73 says that for every 1
Australian Dollar, you get 67.73 Yen.
Currency pairs are generally traded as 100,000 units of the base
currency. For example, if you were buying EUR/USD at .97 you
would be paying Dollars for Euros as follows:
100,000 x .97 = $97,000 for 100,000 Euros
Dominant Base Currencies
Euro - EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD
British Pound - GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD
US Dollar - USD/CAD, USD/JPY, USD/CHF
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Trading Strategies
Trade with money you can
afford to lose
Trading fx markets is speculative and can result in loss, it is
also exciting, exhilarating and can be addictive. The more you
are 'involved with your money' the harder it is to make a
clear-headed decision. Money you have earned is precious, but
money you need to survive should never be traded.
Identify the state of the
market
What is the market doing? Is it trending upwards, downwards, is
it in a trading range. Is the trend strong or weak, did it begin
long ago or does it look like a new trend that's forming.
Getting a clear picture of the market situation is laying the
groundwork for a successful trade.
Determine what time frame
you're trading on
Many traders get in the market without thinking when they would
like to get out, after all the goal is to make money. This is
true but when trading, one must extrapolate in his mind's eye
the movement that one expects to happen. Within this
extrapolation, resides a price evolution during a certain period
of time. Attached to this is the idea of exit price. The
importance of this is to mentally put your trade in perspective
and although it is clearly impossible to know exactly when you
will exit the market, it is important to define from the outset
if you'll be 'scalping' (trying to get a few points off the
market) trading intra-day, or going longer term. This will also
determine what chart period you're looking at. If you trade many
times a day, there's no point basing your technical analysis on
a daily graph, you'll probably want to analyse 30 minute or hour
graphs. Additionally it is important to know the different time
periods when various financial centers enter and exit the market
as this creates more or less volatility and liquidity and can
influence market movements.
Time your trade
You can be right about a potential market movement but
be too early or too late when you enter the trade. Timing
considerations are twofold, an expected market figure like CPI,
retail sales or a federal reserve decision can consolidate a
movement that's already underway. Timing your move means knowing
what's expected and taking into account all considerations
before trading. Technical analysis can help you identify when
and at what price a move may occur. We will look at technical
analysis in more detail later.
If in doubt, stay out
If you're unsure about a trade and find you're
hesitating, stay on the sidelines.
Trade logical transaction
sizes
Margin trading allows the fx trader a very large amount of
leverage, trading at full margin capacity (in ACM's case 1% or
0.5%) can make for some very large profits or losses on an
account. Scaling your trades so that you may re-enter the market
or make transactions on other currencies is generally wiser. In
short, don't trade amounts that can potentially wipe you out and
don't put all your eggs in one basket. ACM offers the same rates
regardless of transaction sizes so a customer has nothing to
lose by starting small.
Gauge market sentiment
Market sentiment is what most of the market is perceived to be
feeling about the market and therefore what it is doing or will
do. This is basically about trend. You may have heard the term
'the trend is your friend', this basically means that if you're
in the right direction with a strong trend you will make
successful trades. This of course is very simplistic, a trend is
capable of reversal at any time. Technical and fundamental data
can indicate however if the trend has begun long ago and if it
is strong or weak.
Market expectation
Market expection relates to what most people are expecting as
far as upcoming news is concerned. If people are expecting an
interest rate to rise and it does, then there usually will not
be much of a movement because the information will already have
been 'discounted' by the market, alternatively if the adverse
happens, markets will usually react violently.
Use what other traders
use
In a perfect world, every trader would be looking at a 14 day
RSI and making trading decisions based on that. If that was the
case, when RSI would go under the 30 level, everyone would buy
and by consequence the price would rise. Needless to say, the
world is not perfect and not all market participants follow the
same technical indicators, draw the same trendlines and identify
the same support & resistance levels. The great diversity of
opinions and techniques used translates directly into price
diversity. Traders however have a tendency to use a limited
variety of technical tools. The most common are 9 and 14 day RSI,
obvious trendlines and support levels, fibonnacci retracement,
MACD and 9, 20 & 40 day exponential moving averages. The closer
you get to what most traders are looking at, the more precise
your estimations will be. The reason for this is simple
arithmetic, larger numbers of buyers than sellers at a certain
price will move the market up from that price and vice-versa.
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Advantages
Over Stock Trading
If you are interested in online
currency trading, you will find the forex market offers several
advantages over stock and futures trading. The advantages of
forex trading are as follow:
24-hour forex
trading
Forex is a true 24-hour market.
Whether it's 6 PM or 6 AM, somewhere in the world there are
buyers and sellers actively trading foreign currencies. Traders
involved in forex trading can always respond to breaking news
immediately, and profit and loss is not affected by after hours
earning reports, analyst conference calls, nor trading stoppages
due to "pending news" or announcements.
After hours trading for U.S.
stocks and futures 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 50 times larger than the New York Stock Exchange, there are
always broker/dealers willing to buy or sell currencies in the
forex markets. The liquidity of the forex 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. This is a huge advantage of forex trading.
Because of the lower trade
volume, investors in the stock market and other exchange-traded
markets 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
in forex trading
100 to 1 leverage is commonly
available from online forex dealers, which substantially exceeds
the common 2:1 margin offered by equity brokers, and 15:1 in the
futures market. At 50:1, traders post $2000 margin for a
$100,000 position, or 2%.
While certainly not for everyone,
the substantial leverage available from online forex 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 forex trading is to diligently
follow a disciplined trading style that consistently utilizes
stop and limit orders. Devise and adhere to a forex trading
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.
Commissions for stock trades in
the online discount brokerage world typically range from
$7.95-$29.95 per trade, with full service brokers typically
charging $100 or more per trade. An average commission on a
futures trade is $15 a round turn. Forex brokers offer much
lower commission structures. Thus, investors involved in forex
trading could limit their cost.
Equal profit
potential in both rising and falling markets
In every open forex position, an
investor is long in one currency and short the other. A short
position is one in which the trader sells the base currency in
anticipation that it will depreciate. This means that, in forex
trading, 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. This limitation does not exist in forex
trading.
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Base currency: The
base currency is the first currency in a currency pair, and the
currency that remains constant when determining a currency
pair's price. The United States Dollar (USD) and the European
Union Euro(EUR) are the dominant base currencies in terms of
daily traded volume in the foreign exchange market. The British
Pound (GBP), also called sterling or cable, is the third ranking
base currency. The USD based pairs are USD/JPY, USD/CHF and USD/CAD;
the Euro based pairs are EUR/USD, EUR/JPY, EUR/GBP, and EUR/CHF.
The GBP is the base for GBP/USD and GBP/JPY. The Australian
Dollar (AUD) is its own base against the USD (AUD/USD).
Basis: The
difference between the spot price and the futures price.
Basis point: One
hundredth of a percentage point.
Bid /Ask Spread: The
difference between the bid and offer (ask) prices; also known as
a two-way price.
Cable: Trader
term for the British Pound Sterling referring to the Sterling/US
Dollar exchange rate. Term began due to the fact that the rate
was originally transmitted via a transatlantic cable starting in
the mid 1800's.
Central bank: The
principal monetary authority of a nation, controlled by the
national government. It is responsible for issuing currency,
setting monetary policy, interest rates, exchange rate policy
and the regulation and supervision of the private banking
sector. The Federal Reserve is the central bank of the United
States. Others include the European Central Bank, Bank of
England, and the Bank of Japan.
Conversion: The
process by which an asset or liability denominated in one
currency is exchanged for an asset or liability denominated in
another currency.
Cross rates: An
exchange rate between two currencies. The cross rate is said to
be non-standard in the country where the currency pair is
quoted. For example, in the US , a GBP/CHF quote would be
considered a cross rate, whereas in the UK or Switzerland it
would be one of the primary currency pairs traded.
Currency: A
country's unit of exchange issued by their government or central
bank whose value is the basis for trade.
Currency (exchange rate)
risk: The
risk of incurring losses resulting from an adverse change in
exchange rates.
Devaluation: Lowering
of the value of a country's currency relative to the currencies
of other nations. When a nation devalues its currency, the goods
it imports become more expensive, while its exports become less
expensive abroad and thus more competitive.
Drawdown: The
magnitude of a decline in account value, either in percentage or
dollar terms, as measured from peak to subsequent trough. For
example, if a trader's account increased in value from $10,000
to $20,000, then dropped to $15,000, then increased again to
$25,000, that trader would have had a maximum drawdown of $5000
(incurred when the account declined from $20,000 to $15,000)
even though that trader's account was never in a loss position
from inception.
End of day (mark to
market): Mark-to-market values a trader`s open
position at the end of each working day using the closing market
rates or revaluation rates. Generally the revaluation rates are
market rates at 5pm EST time. Any profit or loss is booked and
the trader will start the next day with the position valued at
the prior day's closing rate.
Euro: The
currency of the European Monetary Union (EMU), which replaced
the European Currency Unit (ECU). The countries currently
participating in the EMU are Germany, France, Belgium,
Luxembourg, Austria, Finland, Ireland, the Netherlands, Greece,
Italy, and Spain.
Exchange rate: The
price of one currency stated in terms of another currency.
Example: $1 Canadian Dollar (CDN) = $0.7700 US Dollar (USD)
Fixed exchange rate: A
country's decision to tie the value of its currency to another
country's currency, gold (or another commodity) , or a basket of
currencies . In practice, even fixed exchange rates fluctuate
between definite upper and lower bands, leading to intervention.
Foreign exchange (Forex): The
simultaneous buying of one currency and selling of another in an
over-the-counter market.
G-7: The
seven leading industrial countries, being the United States,
Germany, Japan, France, Britain, Canada, and Italy.
G-10: G7 plus
Belgium , Netherlands and Sweden , a group associated with the IMF discussions. Switzerland is sometimes involved.
G-20: A group
composed of the Finance Ministers and central bankers of the
following 20 countries: Argentina , Australia , Brazil , Canada
, China , France , Germany , India , Indonesia , Italy , Japan ,
Mexico , Russia , Saudi Arabia , South Africa , South Korea ,
Turkey , the United Kingdom , the United States and the European
Union. The IMF and the World Bank also participate. The G-20 was
set up to respond to the financial turmoil of 1997-99 through
the development of policies that “promote international
financial stability”.
Hedge fund: A
private, unregulated investment fund for wealthy investors
(minimum investments typically begin at US$1 million)
specializing in high risk, short-term speculation on bonds,
currencies, stock options and derivatives.
Hedging: A
strategy designed to reduce investment risk. Its purpose is to
reduce the volatility of a portfolio by investing in alternative
instruments that offset the risk in the primary portfolio.
London Inter-Bank Offer
Rate or LIBOR: The standard for the interest rate
that banks charge each other for loans (usually in Eurodollars
). This rate is applicable to the short-term international interbank deposit market, and applies to very large loans
borrowed from one day to five years. This market allows banks
with liquidity requirements to borrow quickly from other banks
with surpluses, enabling banks to avoid holding excessively
large amounts of their asset base as liquid assets. The LIBOR is
officially fixed once a day by a small group of large London
banks, but the rate changes throughout the day.
Leverage: The
degree to which an investor or business is utilizing borrowed
money. The amount, expressed as a multiple, by which the
notional amount traded exceeds the margin required to trade. For
example, if the notional amount traded is $100,000 dollars and
the required margin is $2000, the trader can trade with 50 times
leverage ($100,000/$2000). For investors, leverage means buying
on margin to enhance return on value without increasing
investment. Leveraged investing can be extremely risky because
you can lose not only your money, but the money you borrowed as
well.
Liquidity:
The
ability of a market to accept large transactions. A function of
volume and activity in a market. It is the efficiency and cost
effectiveness with which positions can be traded and orders
executed. A more liquid market will provide more frequent price
quotes at a smaller bid/ask spread.
Long: A
position purchasing a particular currency against another
currency, anticipating that the value of the purchased currency
will appreciate against the second currency.
Margin: Funds
that customers must deposit as collateral to cover any potential
losses from adverse movements in prices.
Margin Call: A
requirement for additional funds or other collateral, from a
broker or dealer, to increase margin to a necessary level to
guarantee performance on a position that has moved against the
customer.
Market Maker: A
dealer that supplies prices, and is prepared to buy and sell at
those bid and ask prices. All CFTC registered FCMs are market
makers.
Pip (tick): The
term used in currency markets to represent the smallest
incremental move an exchange rate can make. Depending on
context, normally one basis point (0.0001 in the case of EUR/USD,
GBD/USD, USD/CHF and .01 in the case of USD/JPY).
Position:
A view
expressed by a trader through the buying or selling of
currencies, and can also refer to the amount of currency either
owned or owed by an investor.
Premium (cost of carry): The
cost or benefit associated with carrying an open position from
one day to the next calculated by using the differential in
short-term interest rates between the two currencies in the
currency pair.
Revaluation: An
increase in the foreign exchange value of a currency that is
pegged to other currencies or gold.
Revaluation rates: The
rate for any period or currency, which is used to revalue a
position or book. The revaluation rates are the market rates
used when a trader runs an end-of-day to establish profit and
loss for the day.
Rollover:
The
settlement of a deal is rolled forward to another value date
with the cost of this process based on the interest rate
differential of the two currencies. An overnight swap,
specifically the next business day against the following
business day.
Short: To
sell a currency without actually owning it, and to hold a short
position with expectations that the price will decrease so that
it can be bought back at a later time at a profit.
Spread:
The
difference between the bid and offer (ask) prices of a currency;
used to measure market liquidity. Narrower spreads usually
signify high liquidity.
Spot Price: Current
market price. Settlement of spot transactions normally occurs
within two business days.
Swaps: A
foreign exchange swap is a trade that combines both a spot and a
forward transaction into one deal, or two forward trades with
different maturity dates.
Uptick: A
new price quote that is higher than the preceding quote for the
same currency.
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