New to Forex
Trading
Introduction
Although the foreign exchange market is the largest
traded market in the world, its reach to the retail
sector pales in comparison to the Equity and Fixed Income
markets. This is in large part due to a general lack
of awareness of FX in the investor community, along
with as a lack of understanding of how and why currencies
move. Adding to the mystique of this market is the lack
of a physical central exchange akin to the NYSE or the
CME. It is this very lack of structure that enables
the FX markets to operate on a 24-hour basis, beginning
the trading day in New Zealand and continuing through
the time zones.
Traditionally, access to the FX market was limited
to the bank community that traded large blocks of currencies
for commercial, hedging, or speculative purposes. The
creation of well-capitalized firms like FXDD has opened
the door of Forex trading to such institutions as funds
and money managers, as well as to the individual retail
trader. This sector of the market has grown exponentially
over the past several years.
What is Foreign Exchange?
For active traders and investors, foreign exchange
should be no different than other investment products
such as equities, commodities or fixed-income. Because
of globalization in the economic world and consolidation
of whole economic regions (i.e., the European Union),
including currencies in a portfolio helps to diversify
assets and can reduce risk.
Just like other investment alternatives, foreign exchange
offers traders/investors a market where they can buy
or sell an investment product. In this case it is a
specific Currency Pair. The currency pair may be the
Euro versus the US Dollar, the US Dollar versus the
Japanese Yen, the British Pound versus the US Dollar,
the Euro versus British Pound, or a number of other
currency combinations.
The different currency combinations represent nothing
more than the value of one currency versus the value
of another. That relationship is represented by a single
price. In foreign exchange, the price of a currency
pair is the market’s expectations (at that time)
of the value of that currency measured against another
currency given the current and expected economic and
political situation in the two economies. In equity
terms, it is the price of the stock.
If, for example, an economy’s inflation/interest
rates are low and stable, if its output is growing strongly,
or if its politics are stable and expectations are for
more of the same, then one can expect (in general) for
that country's currency to remain strong versus a less
fundamentally favorable currency.
Contrasting that with an equity, if the domestic and
global economy is strong, if inflation is not rampant,
if competition is not taking away market share or eating
into margins, if product demand and growth are strong,
of if the companies internal "politics" are
such that the workers are happy and productive, and
expectations are for more of the same, then you can
expect that company’s stock to remain strong versus
a company with less favorable fundamentals.
Similar to equities there are other factors that determine
the short term value of a product including technical
analysis, short term supply and demand, seasonal capital
flow patterns, the current price of the instrument,
etc. It is these universal dynamics that will move a
currency’s value up or down. By analyzing the
pricing dynamics and combining that with sound money
management and discipline, the investor can ensure greater
success in his or her foreign exchange trading.
The Liquid Currency Pairs
Currencies, like equities and bonds, have pairs that
are very liquid and those that are not so liquid. The
liquid currencies can be characterized as those that
are the most stable economically and politically. They
include the countries that form the G7 - the United
States, Japan, Great Britain, France, Germany, Italy,
and Canada.
Since the unification of the European currencies into
the EURO, the currencies that are most liquid now include
the US Dollar, the Japanese Yen, the British Pound,
the Euro, and the Canadian Dollar. It is estimated that
activities in these currencies comprise more than 80%
of the daily foreign exchange volume.
Foreign Currency Symbols
Currencies, like equities, have their own symbols that
distinguish one from another. Since currencies are quoted
in terms of the value of one against the value of another,
a currency pair includes the "name" for both
currencies, separated by a "/". The "name"
is a three letter acronym. The first two letters are
in most cases reserved for identification of the country.
The last letter is the first letter of the unit of currency
for that country. For example,
USD = United States Dollar
GBP = Great Britain Pound
JPY = Japanese Yen
CAD = Canadian Dollar
CHF = Confederatio Helvetica (Latin for Swiss Confederation)
Franc
NZD = New Zealand Dollar
AUD = Australian Dollar
NOK = Norwegian Krona
SEK = Swedish Krona
Since the European Euro has no specific country attached
to it, it goes simply by the acronym EUR.
By combining one currency, EUR, with another USD, you
create a currency pair EUR/USD.
The Base and Counter Currency
One currency in a currency pair is always dominant.
It is called the Base Currency. The base currency is
identified as the first currency in a currency pair.
It also is the currency that remains constant when determining
a currency pair's price.
The Euro is the dominant base currency against all
other global currencies. As a result, currency pairs
against the EUR will be identified as EUR/USD, EUR/GBP,
EUR/CHF, EUR/JPY, EUR/CAD, etc. All have the EUR
acronym as the first in the sequence.
The British Pound is next in the hierarchy of currency
name domination. The major currency pairs versus the
GBP would, therefore be identified as GBP/USD, GBP/CHF,
GBP/JPY, GBP/CAD. Apart from the EUR/GBP, expect to
see GBP as the first currency in a currency pair.
The USD is the next dominant base currency. USD/CAD,
USD/JPY, USD/CHF would be the normal currency pair convention
for the major currencies. Since the EUR and the GBP
are more dominant in terms of base currencies, the dollar
is quoted as EUR/USD and GBP/USD.
Knowing the base currency is important as it determines
the values of currencies (notional or real) exchanged
when a foreign exchange deal is transacted.
The Counter Currency is the second currency in a Currency
Pair notation.
The Value of Currencies
The base currency is ALWAYS equal to one of the currency's
monetary unit of exchange (i.e., 1 Euro, 1 Pound, and
1 Dollar). When an investor buys 100,000 EUR/USD, he
is said to be buying (or receiving) the EURO or the
Base Currency and selling (or paying for) the USD or
Counter Currency. The amount of the Base Currency he
is buying is equal to 100,000 Euros. Note that this
is true no matter the current exchange rate at the time.
The base currency amount remains constant.
The Counter Currency equivalent amount that the investor
is selling (or paying), on the other hand, will fluctuate
with the exchange rate for the Currency Pair.
It is equal to:
(Amount of Base
Currency x Market Foreign Exchange Rate)
Since the Counter Currency is the part of the currency
pair that fluctuates higher or lower, it determines
the strength or weakness of both currencies in a currency
pair. As one currency goes up, the other must go down.
Currencies trade in fractions of a full unit. The smallest
fraction is called a "pip". Currencies trade
in pips because exchanges of currencies for speculative
reasons are generally for large amounts. This is because
of the leverage that is available when trading Foreign
Exchange.
FXDD provides a Maximum Trading Leverage Ratio of 100:1for
standard accounts. At that ratio, a 100,000 EUR position
would require $1,200 of Margin at an exchange rate of
1.2000. This is calculated by taking the US$ equivalent
of 100,000 EUR or US$120,000 and dividing by the 100:1
leverage ratio.
Margin Required = $120,000 / 100 = $1,200
To determine the value of a pip for the deal above
the following calculation would be made:
Value in US$ = 1.20 x Par Amount of Base Currency =
$120,000
Value in US$ + a pip = (1.20+.0001) x Par Amount of
Base Currency = $120,000
The value of a pip in dollars is equal to $120,000
- $119,990 or $10.
When a currency pair goes from a low price to a higher
price, the Base Currency is said to have strengthened
or gotten stronger. The converse is true for the Counter
Currency. That is, it has weakened or gotten weaker
as the Base Currency has gotten stronger.
Since Exchange Rates represent what a fixed amount
of currency is equal to in terms of another currency,
we have seen there is just one price for the Currency
Pair. The movement of that price determines whether
a currency is getting stronger or weaker.
If the EUR/USD exchange rate goes from 1.2000 to 1.2024,
we have concluded that the EUR got stronger, the USD
weaker. Why?
When looking at Foreign Exchange Rates (or prices)
an action to Buy the Currency Pair implies buying the
Base Currency, or EUR, and selling the Counter Currency,
or USD. If the EUR/USD exchange rate moves higher, as
expected, the trader can now sell the EUR/USD at a dearer/higher
price. The difference represents a Profit to the trader
that was Long, or who bought the EUR/USD Currency Pair.
Another way of looking at it is at 1.2000, an investor/trader
could exchange 1 EUR for $1.20. At 1.2100, however,
that same single EUR can now be exchanged for a higher
amount of USD, in this case $1.21 USD. The EUR has strengthened
or gotten stronger.
Transacting Foreign Exchange Fundamentals
Buying and
Selling Foreign Exchange
What exactly do you buy or sell when you make a foreign
currency transaction?
In reality, you are doing both actions - buying and
selling. A transaction of Buying the EUR/USD at 1.2000
is actually buying the Euro and selling the Dollars
at 1.2000 cents. If the Euro increases in value in relation
to the dollar, the price would increase and the investor
will make money.
If for whatever reason, a trader could not execute
an order using FXDD, a verbal order to a broker could
be the following:
"I buy 100,000 Euros and sell the
dollar at the Market"
or
"I buy 500,000 EUR/USD on a 1.2100 stop"
or
"I buy 100,000 Euros vs. the Dollar at the market"
What is required on all verbal orders is the amount,
the Currency Pair, the rate and/or the type of order.
Simply saying "I buy the Dollar at the Market"
is not good enough as it does not say what currency
the trader wants to sell.
The Bid/Ask
Price
Like equities, foreign exchange has a Bid price and
an Ask price. The bid is where the market maker will
buy. The ask is where the market maker will sell. For
investors, the reverse is true. The bid price is where
an investor can sell, while the ask is where an investor
can buy.
The bid price is always less than the ask price. This
makes logical sense as a market maker, like any investor,
wants to buy low and sell high.
The spread between the bid and the ask is called the
Bid/Ask Spread or Dealing Spread. The bid/ask spread
is the premium that market makers charge to provide
constant liquidity to a retail client base. For example,
the bid and ask might be 1.2050/1.2055. The spread is
5 pips.
Paralleling foreign exchange trading to equities, a
market maker, like FXDD, is the equivalent of a specialist
on the floor of the exchange.
A specialist is always willing and able to make a market
(i.e. provide liquidity) to the market/investor. For
this service, he will have a bid where he buys the stock
and an offer or ask, where he will sell the stock. The
bid/ask spread the specialist charges will fluctuate
with the general liquidity of the underlying stock.
That same principle applies to FXDD's Bid/Ask Spreads.
Dealing Spreads for the major currencies pairs on FXDD
are 2-3 pips wide. Some less liquid currencies will
be a bit wider. This reflects the relative liquidity/risk
in the professional market for that particular currency
pair. The dealing spreads that we quote reflect a normal
market making spread given the risks we take and the
costs we incur for servicing our clients' business.
Obviously, if the volatility and risk of making a market
increase because the markets become less liquid, it
stands to reason that our spreads will increase as well.
These are universal realities of market makers and should
not come as a surprise to knowing investors/traders.
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