Intro to Forex and Futures

Intro to Forex and Futures 1

Forex Trading Forex is a term meaning foreign exchange, and refers to trading the currency of one country against the currency from another country simultaneously. Over $1.4 trillion US dollars is traded in the foreign exchange market each day, and over the course of the last 30 years, this market has become the world's largest financial market. The daily volume of NYSE, in contrast, averages just $25 billion a day. Trading is carried out over-the-counter, 24 hours daily except over the weekends, as there is no existence of physically located central exchange. It is only recently that Forex market trading became acceptable for the average trader. The requirements of excessive minimum transaction sizes and frequently demanding financial qualifications limited main participants to banks, hedge funds, large currency dealers and sometimes the high net-worth individual. These big traders were able to enjoy the abundant advantages that the Forex market provides, such as tremendous liquidity and the powerful trending tendency of the globe's major currency exchange rates. The investor or trader is seeking to buy or sell one currency in favor of another with the idea of gaining a profit when the value of the currencies moves favorably for the investor, whether because of market news or worldwide current events taking place at the time of the trade. Ninety-five percent of the volume is trading or speculation. The additional 5% of the everyday volume includes governments and commercial businesses changing one currency into another one when purchasing and marketing goods and services. 2

The currencies that are traded most often are called the Majors. These include: US Dollar (USD) Japanese Yen (JPY) Euro (EUR) British Pound (GBP) Canadian Dollar (CAD) Australian Dollar (AUD) Swiss Franc (CHF) When traded in pairs, the most common pairs are: US Dollar and the Japanese Yen (USD/JPY) Euro and US Dollar (EUR/USD) US Dollar and Swiss Franc (USD/CHF) In this market, it is possible to purchase or sell currencies. The goal is to win some money from your position. Making a trade using a foreign exchange market is easy: The mechanism of the trade is actually the same as those in various markets, so it is easy for a lot of traders to make the transition. Understanding Forex Quotes If you are unfamiliar with trading, understanding a foreign exchange quote may seem a bit confusing. However, it becomes quite simple if you remember two things: 1. The first currency listed is the base currency. 2. The value of the base currency is always 1. When looking at price charts you will often see a two-sided quote, consisting of a bid' and ask'. The bid' is the price at which you can sell the base currency while 3

simultaneously buying the counter currency. The ask' is the price at which you can buy the base currency and sell the counter currency. The US dollar is the current world currency and is generally the base currency for quotes. For example, a quote of USD/JPY 105.14 means that one US dollar is equal to 105.14 Japanese Yen. When the US Dollar is the base currency and the quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote increases to 106.25, the dollar has become stronger because it will now buy more yen than before. There are three common exceptions to this rule where the USD is not the base currency. These common currency pairs include the British Pound (GBP), the Australian Dollar (AUD), and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.8918. In these three currency pairs, where the US Dollar is not the base currency, a rising quote means the dollar has weakened, in other words it now takes more US Dollars to equal one pound, Euro, or Australian Dollar. Cross currencies are defined as currency pairs that do not involve the US dollar. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese Yen. Let's review a sample trade: Forex trades are always done between two currency pairs of different countries. In this example we will look at the EUR/USD. 4

Name Bid Ask High Low EUR/USD 1.1901 1.1903 1.2024 1.1891 If we decide to trade the EUR/USD currency pair, we note that the ask price, or the price at which the broker is willing to sell the EUR for is 1.1903. In this example that means we can buy the base currency EUR for $1.1903. The bid price, or the price at which the broker is willing to buy the EUR, is listed as 1.1901. In this example that means we can sell the base currency EUR for $1.1901. Traditionally, all trades were done in standard lots or 100,000 units, so to trade 100,000 units you would theoretically have to have $119,030 to purchase one standard lot of 100,000 Euros. For most traders, that is an enormous amount of money. For a long time, investors have sought the ability to trade with leverage or control much more shares than can be bought at the standard market price. To accommodate this need, Forex brokers 'loan' an investor typically up to 90% or more so that this leverage can be exercised. It isn't technically a loan. The 10% or whatever is actually invested is regarded, in the industry and in law, as a 'good faith deposit'. The investor is legally responsible for the other 90% or more. This is very important to understand, but it's very rare that most investors will hold positions long enough whereby payment of this leveraged capital is actually mandated. If however, the price moves in an unfavorable direction for the investor by a large enough amount, the broker will liquidate the position and the investor will have to cover his or her loss. It's important to realize this! A good broker will usually give the client a call and give the option to input enough fresh cash to cover the shortfall. 5

In highly volatile markets, currency prices can change by significant amounts very quickly so be prepared and monitor your trades. In the example above, the EUR/USD is 1.1901/03. This is another way of illustrating that the bid price is 1.1901 and the ask price is 1.1903. If you trade this currency pair at 1:10 (10%) leverage and buy one standard lot (100,000 units) of the EUR, you would be required to have 10% of $119,030, or $11,903.00 in your account. Let s assume that the price moves favorably in your position and we decide to capture the profit potential of the trade. If the market moves to EUR/USD 1.1907/09 and you decide to sell the Euro at that point, the sale will occur at the bid price. In this case your profit would be $119,070 - $119,030 = $40. That doesn't sound like much, but observe two things. First, the initial investment was only $11,903.00, and 10% of $119,070 = $11,907.00, only a $4 difference. But the actual profit that was achieved was10 times that at $40. This is the benefit of trading leveraged investments. However, it must also be noted that this same leverage can and will work against you if the trade moves in an unfavorable direction. Second, price changes of a few pips can occur rapidly in the Forex market. For the leveraged trader who wants to take advantage of these rapid moves in price, large amounts of capital can be made (or lost) very quickly. It is interesting to note that there are no formal commissions exercised in the Forex markets, instead brokers make their money off the difference in the currency spread 6

or the difference between the ask and bid. This is an important consideration when trading Forex as these spreads must be considered as a tangible cost to trading the Forex markets. The National Futures Association (NFA) has prepared a complimentary online training guide entitled Forex Online Learning Program ; you can view this slideshow tutorial by visiting: http://www.nfa.futures.org/forex_training/content/coverpage.htm 7

Futures Trading A futures contract is a commitment to buy or sell a commodity on or prior to a specified future date, at a consensual price today. Financial instruments and stock indexes are good examples of commodities along with the traditional examples like corn and silver. Futures have the benefit that trading contracts between buyer and seller are provided with an organized, regulated exchange. Of the many benefits possible from exchange-traded futures, perhaps the most important is managing and reducing the price risk of commodities and financial instruments. A clear example would be a tortilla maker worried about a price spike in corn who could protect himself by buying a futures contract in corn to hedge his risk. Not all futures contracts stipulate that a product be delivered; some state that cash be used to finalize the transaction. Generally speaking, an obligation to purchase or sell is counter-balanced by liquidation of the position. For instance, if you purchase one contract of S&P500 e-mini, all you have to do to liquidate the position is to sell one contract of S&P500 e-mini. The amount of a trade's gain or loss is calculated by subtracting the purchase from the selling amount, minus transaction expenses. A profit or loss from a futures deal is determined each day and is indicated on the nightly trading statement. This is called daily cash settlement. The National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) are responsible for overseeing US futures trading. Stationed in Washington, DC, the CFTC is an independent federal agency that supports and enforces laws associated with the Commodity Exchange Act and oversees industry self-governing organizations. The NFA, with its main office located in Chicago, is a self-regulated business with operations that consist of industry professional registration, including auditing and arbitration. 8

Margin and Risk Margin, in the market of futures trading, refers to the minimum required deposit that your brokerage can use, on a daily basis, to resolve losses that may arise. The two concepts that are important to know are initial and maintenance margin. The exchange decides the amounts for these figures, and they can go up or down based on market activity. And so, frequently a reason to raise margins is an increase in the volatility of the market, and the daily price movement range. Initial margin is the minimum fund your account must possess for every futures contract to be bought, sold, and kept overnight. The minimum margin requirement for the S&P500 e-mini contract is currently at $5000, which is the amount you must have in your account in order to keep the position overnight. Overnight, in this situation, is defined at the end of the day in the market (3:15pm Central Time for the S&P500 e-mini). After you have held a position for a day, the stock exchange reduces the margin requirement to permit for changes in market movement. This latest margin level is referred to by the term 'maintenance margin'. Once the value of your account drops under the margin requirement, you are required to add more funds to bring the balance over the specified level. It is important to understand the rules imposed by your brokerage firm before you begin trading, as they will be able to liquidate your positions at the current market price if necessary. The National Futures Association (NFA) has prepared an online tutorial program entitled An Online Learning Guide to Trading Futures which you can find in the course index. 9

U.S. Government Required Disclaimer - Commodity Futures Trading Commission. Forex, Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This website is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this website. The past performance of any trading system or methodology is not necessarily indicative of future results. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. Substantial risk is involved. Forex trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the Forex markets. Don't trade with money you can't afford to lose. Nothing in our course or website shall be deemed a solicitation or an offer to Buy/sell futures and/or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on our site. Also, the past performance of any trading methodology is not necessarily indicative of futures results. Trading involves high risks and you can lose a lot of money. 10