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Trading Forex - An
Introduction
A Little
Forex History
The purpose of these articles is to introduce the forex market
to you. As with many markets there are many derivative of the
central market such as futures, options and forwards. In this
book we will only be discussing the main market sometime
referred to as the Spot or Cash market.
The word FOREX is derived from the words Foreign Exchange and
is the largest financial market in the world. Unlike many
markets the FX market is open 24 hours per day and has an
estimated $1.2 Trillion in turnover every day. This tremendous
turnover is more than the combined turnover of the main
worlds' stock markets on any given day. This tends to lead to
a very liquid market and thus a desirable market to trade.
Unlike many other securities (any financial instrument that
can be traded) the FX market does not have a fixed exchange.
It is primarily traded through banks, brokers, dealers,
financial institutions and private individuals.
Trades are executed through phone and increasingly through the
Internet. It is only in the last few years that the smaller
investor has been able to gain access to this market.
Previously the large amounts of deposits required precluded
the smaller investors. With the advent of the Internet and
growing competition it is now easily within the reach of most
investors.
INTERBANK
You will often hear the term INTERBANK discussed in FX
terminology. This originally, as the name implies was simply
banks and large institutions exchanging information about the
current rate at which their clients or themselves were
prepared to buy or sell a currency.
INTER meaning between and Bank meaning deposit taking
institutions. The market has moved on to such a degree now
that the term interbank now means anybody who is prepared to
buy or sell a currency.
It could be two individuals or your local travel agent
offering to exchange Euros for US Dollars. You will however
find that most of the brokers and banks use centralized feeds
to insure reliability of quote.
The quotes for Bid (buy) and Offer (sell) will all be from
reliable sources. These quotes are normally made up of the top
300 or so large institutions. This insures that if they place
an order on your behalf that the institutions they have placed
the order with is capable of fulfilling the order.
Now although we have spoken about orders being fulfilled, it
is estimated that anywhere from 70%-90% of the FX market is
speculative. In other words the person or institution that
bought or sold the currency has no intention of actually
taking delivery of the currency. Instead they were solely
speculating on the movement of that particular currency.
Source: Bank For International Settlements http://www.bis.org
Extract From The Triennial Central Bank Survey of Foreign
Exchange and Derivatives Market Activity.
As you can
see from the above table over 90% of all currencies are traded
against the US Dollar. The four next most traded currencies
are the Euro (EUR), Japanese Yen (JPY), Pound Sterling (GBP)
and Swiss Franc (CHF).
As currencies are traded in pairs and exchanged one for the
other when traded, the rate at which they are exchanged is
called the exchange rate. These four currencies traded against
the US Dollar make up the majority of the market and are
called major currencies or the majors.
As you can see from the above table over 90% of all currencies
are traded against the US Dollar. The four next most traded
currencies are the Euro (EUR), Japanese Yen (JPY), Pound
Sterling (GBP) and Swiss Franc (CHF).
As currencies are traded in pairs and exchanged one for the
other when traded, the rate at which they are exchanged is
called the exchange rate. These four currencies traded against
the US Dollar make up the majority of the market and are
called major currencies or the majors.
Market Mechanics
So now we know that the FX market is the largest in the world
and that your broker or institution that you are trading with
is collecting quotes from a centralized feed or individual
quotes comprising of interbank rates.
So how are these quotes made up? Well, as we previously
mentioned currencies are traded in pairs and are each assigned
a symbol. For the Japanese Yen it is JPY, for the Pounds
Sterling it is GBP, for Euro it is EUR and for the Swiss Frank
it is CHF. So, EUR/USD would be Euro-Dollar pair. GBP/USD
would be pounds Sterling-Dollar pair and USD/CHF would be
Dollar-Swiss Franc pair and so on.
You will always see the USD quoted first with few exceptions
such as Pounds Sterling, Euro Dollar, Australia Dollar and New
Zealand Dollar. The first currency quoted is called the base
currency. Have a look below for some example.
When you see FX quotes you will actually see two numbers. The
first number is called the bid and the second number is called
the offer (sometimes called the ASK).
If we use the EUR/USD as an example you might see
0.9950/0.9955 the first number 0.9950 is the bid price and is
the price traders are prepared to buy Euros against the USD
Dollar. The second number 0.9955 is the offer price and is the
price traders are prepared to sell the Euro against the US
Dollar.
These quotes are sometimes abbreviated to the last two digits
of the currency such as 50/55. Each broker has its own
convention and some will quote the full number and others will
show only the last two.
You will also notice that there is a difference between the
bid and the offer price and that is called the spread. For the
four major currencies the spread is normally 5 give or take a
pip (will explain pips later)
To carry on from the symbol conventions and using our previous
EUR quote of 0.9950 bid, that means that 1 Euro = 0.9950 US
Dollars. In another example if we used the USD/CAD 1.4500 that
would mean that 1 US Dollar = 1.4500 Canadian Dollars.
The most common increment of currencies is the PIP. If the EUR/USD
moves from 0.9550 to 0.9551 that is one pip. A pip is the last
decimal place of a quotation. The pip or POINT as it is
sometimes referred to depending on context is how we will
measure our profit or loss.
As each currency has its own value, it is necessary to
calculate the value of a pip for that particular currency. We
also want a constant so we will assume that we want to convert
everything to US Dollars. In currencies where the US Dollar is
quoted first the calculation would be as follows.
Example JPY rate of 116.73 (notice the JPY only goes to two
decimal places, most of the other currencies have four decimal
places)
In the case of the JPY 1 pip would be .01 therefore
USD/JPY: (.01 divided by exchange rate = pip value) so
.01/116.73=0.0000856. It looks like a big number but later we
will discuss lot (contract) size later.
USD/CHF: (.0001 divided by exchange rate = pip value) so
.0001/1.4840 = 0.0000673
USD/CAD: (.0001 divided by exchange rate = pip value) so
.0001/1.5223 = 0.0001522
In the case where the US Dollar is not quoted first and we
want to get to the US Dollar value we have to add one more
step.
EUR/USD: (0.0001 divided by exchange rate = pip value) so
.0001/0.9887 = EUR 0.0001011 but we want to get back to US
Dollars so we add another little calculation which is EUR X
Exchange rate so 0.0001011 X 0.9887 = 0.0000999 when rounded
up it would be 0.0001.
GBP/USD: (0.0001 divided by exchange rate = pip value) so
0.0001/1.5506 = GBP 0.0000644 but we want to get back to US
Dollars so we add another little calculation which is GBP X
Exchange rate so 0.0000644 X 1.5506 = 0.0000998 when rounded
up it would be 0.0001.
By this time you might be rolling your eyes back and thinking
do I really need to work all this out, and the answer is no.
Nearly all the brokers you will deal with will work all this
out for you. They may have slightly different conventions, but
it is all done automatically. It is good however for you to
know how they work it out. In the next section we will be
discussing how these seemingly insignificant amounts can add
up.
More On Market Mechanics
Spot Forex is traditionally traded in lots also referred to as
contracts. The standard size for a lot is $100,000. In the
last few years a mini lot size has been introduced of $10,000
and this again may change in the years to come.
As we mentioned on the previous page currencies are measured
in pips, which is the smallest increment of that currency. To
take advantage of these tiny increments it is desirable to
trade large amounts of a particular currency in order to see
any significant profit or loss. We shall cover leverage later
but for the time being let's assume that we will be using
$100,000 lot size. We will now recalculate some examples to
see how it effects the pip value.
USD/JPY at an exchange rate of 116.73
(.01/116.73) X $100,000 = $8.56 per pip
USD/CHF at an exchange rate of 1.4840
(0.0001/1.4840) X $100,000 = $6.73 per pip
In cases where the US Dollar is not quoted first the formula
is slightly different.
EUR/USD at an exchange rate of 0.9887
(0.0001/ 0.9887) X EUR 100,000 = EUR 10.11 to get back to US
Dollars we add a further step
EUR 10.11 X Exchange rate which looks like EUR 10.11 X 0.9887
= $9.9957 rounded up will be $10 per pip.
GBP/USD at an exchange rate of 1.5506
(0.0001/1.5506) X GBP 100,000 = GBP 6.44 to get back to US
Dollars we add a further step
GBP 6.44 X Exchange rate which looks like GBP 6.44 X 1.5506 =
$9.9858864 rounded up will be $10 per pip.
As we said earlier your broker might have a different
convention for calculating pip value relative to lot size but
however they do it they will be able to tell you what the pip
value for the currency you are trading is at that particular
time. Remember that as the market moves so will the pip value
depending on what currency you trade.
So now we know how to calculate pip value lets have a look at
how you work out your profit or loss. Let's assume you want to
buy US Dollars and Sell Japanese Yen. The rate you are quoted
is 116.70/116.75 because you are buying the US you will be
working on the 116.75, the rate at which traders are prepared
to sell.
So you buy 1 lot of $100,000 at 116.75. A few hours later the
price moves to 116.95 and you decide to close your trade. You
ask for a new quote and are quoted 116.95/117.00. As you are
now closing your trade and you initially bought to enter the
trade you now sell in order to close the trade and you take
116.95 the price traders are prepared to buy at. The
difference between 116.75 and 116.95 is .20 or 20 pips. Using
our formula from before, we now have (.01/116.95) X $100,000 =
$8.55 per pip X 20 pips =$171
In the case of the EUR/USD you decide to sell the EUR and are
quoted 0.9885/0.9890 you take 0.9885. Now don't get confused
here. Remember you are now selling and you need a buyer. The
buyer is biding 0.9885 and that is what you take. A few hours
later the EUR moves to 0.9805 and you ask for a quote.
You are quoted 0.9805/0.9810 and you take 0.9810. You
originally sold EUR to open the trade and now to close the
trade you must buy back your position. In order to buy back
your position you take the price traders are prepared to sell
at which is 0.9810. The difference between 0.9810 and 0.9885
is 0.0075 or 75 pips. Using the formula from before, we now
have (.0001/0.9810) X EUR 100,000 = EUR10.19: EUR 10.19 X
Exchange rate 0.9810 =$9.99($10) so 75 X $10 = $750.
To reiterate what has gone before, when you enter or exit a
trade at some point your are subject to the spread in the
bid/offer quote. As a rule of thumb when you buy a currency
you will use the offer price and when you sell you will use
the bid price.
So when you buy a currency you pay the spread as you enter the
trade but not as you exit and when you sell a currency you pay
no spread when you enter but only when you exit. |
