NEW TO FOREX? WHAT IS FOREIGN EXCHANGE Foreign Exchange (FX or Forex) is one of the largest and most liquid financial markets in the world. According to the authoritative Triennial Central Bank Survey from Bank for International Settlements, Basel, average daily turnover in April 2007 exceeded USD 3.2 trillion, and evidence suggests that the market is still expanding. The spot market accounts for around a third of activity in the FX market. FX is simple to understand once it is realized that a currency is effectively a commodity whose value can change against other currencies, as well as other assets, such as gold and oil. Page 1 WHAT IS FX TRADING In an FX transaction, one currency is sold in exchange for another one. The rate expresses the relative value between the two currencies. Currencies are normally identified by a three-digit Swift code. For instance, EUR = the euro, USD = the US dollar, CHF = the Swiss franc and so on. A full list of codes can be found here. A EUR/USD rate of 1.3000 means that EUR 1 is worth USD 1.30. Sometimes, EUR/USD is referred to as a currency pair. The rate can be inverted. So a EUR/USD rate of 1.5000 is the same as a USD/EUR rate of 0.6666. In other words, USD 1 is worth EUR 0.6666. The market convention is that most currencies tend to be quoted against the dollar, but there are notable exceptions, such as with the EUR/USD already mentioned, GBP/USD (UK sterling) and AUD/USD (the Australian dollar). This is not as confusing as it may sound. FOREIGN EXCHANGE RATE SYSTEMS There are basically two types of exchange rate systems: Flexible Exchange Rate System In a flexible exchange rate system, a currency is free to float and its value is determined by market forces.
Fixed Exchange Rate System In a fixed exchange rate system, a currency is not allowed to fluctuate freely. Instead, its value is fixed either against a single currency, such as the USD, at a specific rate, or a basket of currencies. In a fixed system, the local central bank will use its currency reserves to prevent rate movements. Page 2 MAJOR INFLUENCES ON FX PRICES There are numerous factors that determine a free floating currency s worth in the market, from international trade flow, economic and political conditions, the level of interest rates to simple short-term supply and demand. Unlike many other assets, FX is a pure market and rates move freely both up and down. OVER-THE-COUNTER MARKET The Forex market is an 'over the counter market' (OTC), which means that there is no physical location and no central exchange and clearing hours where orders are matched. Instead, it operates 24-hours a day via an electronic network of banks, corporations and individuals trading one currency for another. FX traders constantly negotiate prices between one another and the resulting market bid/ask prices are then fed into computers and displayed on official quote screens. Forex exchange rates quoted between banks are referred to as Inter-bank Rates. FX MARKET PARTICIPANTS There are numerous different types of participants in the FX market and frequently they are looking for very different outcomes when they trade. This is why that although FX is often described as a zero-sum game what one investor makes is equal in theory to what another has lost there are numerous opportunities to make money. FX can be thought of as a pie from which everyone can have a decent meal. Traditionally, banks have been the main participants in the FX market. They still remain the largest players in terms of market share, but transparency has made the FX market far more democratic. Now virtually everyone has access to the same, extremely narrow prices that are quoted in the interbank market. Banks remain the main players in the FX market, but a new breed of market makers, such as hedge funds and commodity trading advisors, has emerged over the past decade.
Central Banks can also play an important role in the FX market, while international corporations have a natural interest to trade on account of their exposure to FX risk. Retail FX has expanded rapidly over the past decade and while precise figures are hard to come by, this sector is believed to represent as much as 20% of the FX market. Page 3 SPOT FX VERSUS CURRENCY FUTURES While most FX trading takes place OTC, there is also a quite vibrant and successful futures market. Turnover on the CME, based in Chicago is around US USD 85 billion a day. Several other exchanges also offer currency futures. Typically, spot FX prices are for T+2 settlements. That means trades which are not closed out are settled in 2-working days. Futures tend to have a maturity of 3-months and so are settled quarterly, normally in March, June, September and December. This is why futures prices often look different from spot. In reality, they are almost 100% correlated. The FX market is too efficient not to arbitrage out any price discrepancies. The futures price includes the forward rates of currency pairs. Generally, futures prices are quoted as the US dollar versus the currency in other words, a futures price is the inversion of the spot rate, plus the swap price to the maturity date. Again, this is not as complicated as it sounds. Where to trade is a matter of choice and both the OTC and the futures markets have their merits. But the OTC market does offer more flexibility and it is generally cheaper to trade in. ADVANTAGE OF FX TRADING 24 Hour Market FX is a global market that never sleeps. It is active 24-hours a day for almost 7-days a week. Most activity takes place between the time the New Zealand market opens on Monday, which is Sunday evening in Europe, until the US market closes on Friday evening. Liquidity The FX market is huge and it is still expanding. Daily average volume now exceeds USD 3.2 trillion. Technology has made this market accessible to almost anyone and retail traders have flocked to FX. Leverage FX margin ratios tend to be higher than those available in equity because it is more liquid there is nearly always a price in FX and it tends to be less volatile.
Narrow Spreads Spreads, the difference between the bid and offer price, in FX are miniscule. Just compare a 2-pip price in EUR/USD with a price in even the most active and liquid equity issue. Furthermore, FX prices are typically good for far larger amounts than in equity. The spread is the hidden, intrinsic cost of dealing and in FX it is minimal. Technology has made these tight prices available to almost everyone. No Commission or Transaction Costs The majority of OTC FX business is commission free and with such narrow spreads, the intrinsic cost of trading is far lower than in other assets, such as equity. Profit potential regardless of market direction FX is a pure market. Prices can just as easily go up as down. If a trader believes a currency is about to depreciate, there are seldom restrictions on selling it although if the position is held for more than one day, there is a cost of carry to consider. Profit potential exists in FX regardless of whether a trader is buying or selling and regardless of whether the market is moving up or down. Equal Access to Market Information Despite the introduction of best execution regulations in Europe and the US, few would disagree that professional traders and analysts in the equity market have a huge competitive advantage in comparison to individual traders. In FX, perhaps the only advantage the big banks have is flow information. But FX is a democratic market where virtually all participants have access to the same market moving information as everyone else. Page 4 HOW A FX TRADE WORKS The concept of trading FX is simple, once it is realized that a currency is a commodity whose value fluctuates against another currency. By buying (or selling) a currency, FX Traders look to earn a profit from the movement in the FX rate. The beauty of FX is that the cost of trading is so low. This means that trades can be transacted for the extreme short-term, literally seconds, as well as for a longer duration. Example: A trader believes the EUR is about to increase in value against the USD and buys EUR 1 million at 1.5000. Shortly after, the rate is 1.5050 and the trader closes the position for a US USD 5,000. EUR 1,000,000 at 1.50 = USD 1,500,000 EUR 1,000,000 at 1.5050 = USD 1,505,000 Difference = Profit of USD 5,000
MAJORS There are around 170 currencies in the world. However, activity is concentrated into six major currency pairs, which account for around two-thirds of the total turnover. The Majors are: Page 5 EURUSD (27%) USDJPY (13%) GBPUSD (12%) AUDUSD (6%) USDCHF (5%) USDCAD (4%) CURRENCY PAIRINGS In FX, one currency is always quoted against another. The base currency is the one that can be thought of as the reference. For instance, in a EUR/USD quote, EUR is the base currency and the quote defines how many USD it costs to buy. Similarly, in USD/JPY, USD is the base currency and the rate defines how many JPY it costs to buy. BID AND OFFER (ASKS) The Bid is the price the market is willing to pay for a certain FX currency pair. The offer, or ask, is the price it is prepared to sell at. For example, in a USD/CHF quote of 1.1650/1.653, the bid is 1.1650, while the offer is 1.1653. Frequently, quotes are abbreviated to just the last tow small numbers. In this case, a phone quote would be 50/53. The difference between the bid and the offer is known as the spread. PIPS A Pip (price interest point) represents the smallest fluctuation in price of a currency pair. For most currencies, the rate is quoted to the fourth decimal place, with USD/JPY the notable exception. A pip represents 1/10,000th or 0.0001 of the counter currency. A change of 1 pip for GPB/USD at 1.6319 is 1.6320. The Pip for USD/JPY is only quoted to the second decimal point (1/100th or 0.01).
PROFIT AND LOSS CALCULATIONS Most modern platforms, such as M I G s Trading Station, automatically calculate a trader s profit and loss (P&L) on open positions. This allows traders to keep track as the market moves. Understanding how these calculations work is crucial for all traders. Examples: 1. Sold 3 lots of EURUSD at 1.2175 and bought them at 1.2110: In this example, the client made 65 pips * 3 lots = 195 pips in total profit (as he sold at a higher price than he bought). The pip value for EURUSD is USD 10, so the total profit =195 pips * USD 10 per pip = USD 1,950. 2. Bought 2 lots of USDJPY at 105.60 and sold them at 105.20: In this example, the client made 40 pips * 2 lots = 80 pips in total loss (as he sold at a lower price than he bought). The pip value for USDJPY is 1000 JPY and this equals 1000 / 105.20 (price of USDJPY when the position was closed) = USD 9.506 approximately, and so the client total loss = 80 pips * USD 9.506 per pip = USD 760.46. Page 6 3. Sold 2 lots of EURGBP at 0.7015 and bought them at 0.6940: In this example, the client made 75 pips * 2 LOTS = 150 pips in total profit. The pip value for EURGBP is 10 GBP and this equals 10 * 1.8500 (assuming the price of GBPUSD was 1.8500 when the position was closed) = USD 18.50, and so the total profit is 150 pips * USD 18.50 per pip = USD 2775.