Today, the Forex market is a nonstop cash market where currencies of nations are traded, typically via brokers. Foreign currencies are continually and simultaneously bought and sold across local and global markets. The value of traders' investments increase or decrease based on currency movements. Foreign exchange market conditions can change at any time in response to real-time events.
The main attractions of short-term currency trading to private investors are:
• 24-hour trading, 5 days a week with nonstop access to global Forex dealers. (elsewhere we say the market is 24/7, not 24/5) • An enormous liquid market, making it easy to trade most currencies.
• Volatile markets offering profit opportunities.
• Standard instruments for controlling risk exposure.
• The ability to profit in rising as well as falling markets.
• Leveraged trading with low margin requirements.
• Many options for zero commission trading.
A brief history of the Forex market
The following is an overview into the historical evolution of the foreign exchange market and the roots of the international currency trading, from the days of the gold exchange, through the Bretton-Woods Agreement, to its current manifestation.
The Gold exchange period and the Bretton-Woods Agreement
The Bretton-Woods Agreement, established in 1944, fixed national currencies against the US dollar, and set the dollar at a rate of USD 35 per ounce of gold. In 1967, a Chicago bank refused to make a loan in pound sterling to a college professor by the name of Milton Friedman, because he had intended to use the funds to short the British currency. The bank's refusal to grant the loan was due to the Bretton-Woods Agreement. Bretton-Woods was aimed at establishing international monetary stability by preventing money from taking flight across countries, thus curbing speculation in foreign currencies.
The explosion of the euro market
The rapid development of the Eurodollar market , which can be defined as US dollars deposited in banks outside the US, was a major mechanism for speeding up Forex trading. Similarly, Euro markets are those where currencies are deposited outside their country of origin. The Eurodollar market came into being in the 1950s as a result of the Soviet Union depositing US dollars earned from oil revenue outside the US, in fear of having these assets frozen by US regulators. This gave rise to a vast offshore pool of dollars outside the control of US authorities. The US government reacted by imposing laws to restrict dollar lending to foreigners. Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the late 1980s onwards, US companies began to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing short-term loans and financing imports and exports. London was and remains the principal offshore market. In the 1980s, it became the key center in the Eurodollar market, when British banks began lending dollars as an alternative to pounds in order to maintain their leading position in global finance. London's convenient geographical location (operating during Asian and American markets) is also instrumental in preserving its dominance in the Euro market.
Euro-Dollar currency exchange
The euro to US dollar exchange rate is the price at which the world demand for US dollars equals the world supply of euros. Regardless of geographical origin, a rise in the world demand for euros leads to an appreciation of the euro. Factors affecting the Euro to US dollar exchange rate Four factors are identified as fundamental determinants of the real euro to US dollar exchange rate:
• The international real interest rate differential between the Federal Reserve and European Central Bank
• Relative prices in the traded and non-traded goods sectors
• The real oil price
• The relative fiscal position of the US and Euro zone
The nominal bilateral US dollar to euro exchange is the exchange rate that attracts the most attention. Notwithstanding the comparative importance of bilateral trade links with the US, trade with the UK is, to some extent, more important for the euro.
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Trading Forex
Monday, January 5, 2009
Sunday, January 4, 2009
What is Forex trading. What is a Forex deal ?
The investor's goal in Forex trading is to profit from foreign currency movements. More than 95% of all Forex trading performed today is for speculative purposes (e.g. to profit from currency movements). The rest belongs to hedging (managing business exposures to various currencies) and other activities. Forex trades (trading onboard internet platforms) are non-delivery trades: currencies are not physically traded, but rather there are currency contracts which are agreed upon and performed. Both parties to such contracts (the trader and the trading platform) undertake to fulfill their obligations: one side undertakes to sell the amount specified, and the other undertakes to buy it. As mentioned, over 95% of the market activity is for speculative purposes, so there is no intention on either side to actually perform the contract (the physical delivery of the currencies). Thus, the contract ends by offsetting it against an opposite position, resulting in the profit and loss of the parties involved.
Components of a Forex deal
A Forex deal is a contract agreed upon between the trader and the market-maker. The contract is comprised of the following components:
• The currency pairs (which currency to buy; which currency to sell)
• The principal amount
• The rate
Time frame is also a factor in some deals, but this chapter focuses on Day-Trading (similar to “Spot" or “Current Time" trading), in which deals have a lifespan of no more than a single full day. Thus, time frame does not play into the equation. Note, however, that deals can be renewed
to the next day for a limited period of time. The Forex deal, in this context, is therefore an obligation to buy and sell a specified amount of a particular pair of currencies at a re-determined
exchange rate.
Forex trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a “spot rate", or just “rate", for short). If an investor had bought 1,000 euros on that date, he would have paid 1,199.00 US dollars. If one year later, the Forex rate was 1.2222, the value of the euro has increased in relation to the US dollar. The investor could now sell the 1,000 euros in order to receive 1222.00 US dollars. The investor would then have USD 23.00 more than when he started a year earlier. However, to know if the investor made a good investment, one needs to compare this investment option to alternative investments. At the very minimum, the return on investment (ROI) should be compared to the return on a “risk-free" investment. Long-term US government bonds are considered to be a risk-free investment since there is virtually no chance of default - i.e. the US government is not likely to go bankrupt, or be unable or unwilling to pay its debts.
Trade only when you expect the currency you are buying to increase in value relative to the currency you are selling. If the currency you are buying does increase in value, you must sell back that currency in order to lock in the profit. An open trade is one in which a trader has bought or sold a particular currency pair, and has not yet sold or bought back the equivalent amount to complete the deal. It is estimated that around 95% of the FX market is speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.
Exchange rate
Because currencies are traded in pairs and exchanged one against the other when traded, the rate at which they are exchanged is called the exchange rate. The majority of currencies are traded against the US dollar (USD), which is traded more than any other currency. The four currencies traded most frequently after the US dollar are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or “the Majors". Some sources also include the Australian dollar (AUD) within the group of major currencies.
+ The first currency in the exchange pair is referred to as the base currency
+ The second currency is the counter currency or quote currency
+ The counter or quote currency is thus the numerator in the ratio, and the base currency is
the denominator.
The exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of euros that 1.2083 USD must be paid to obtain 1 euro.
Spreads
It is the difference between BUY and SELL, or BID and ASK. In other words, this is the difference between the market maker's "selling" price (to its clients) and the price the market maker "buys" it from its clients. If an investor buys a currency and immediately sells it (and thus there is no change in the rate of exchange), the investor will lose money. The reason for this is “the spread". At any given moment, the amount that will be received in the counter currency when selling a unit of base currency will be lower than the amount of counter currency which is required to purchase a unit of base currency. For instance, the EUR/USD bid/ask currency rates at your bank may be 1.2015/1.3015, representing a spread of 1,000 pips (percentage in points; one pip = 0.0001). Such a rate is much higher than the bid/ask
currency rates that online Forex investors commonly encounter, such as 1.2015/1.2020, with a spread of 5 pips. In general, smaller spreads are better for Forex investors since they require a smaller movement in exchange rates in order to profit from a trade.
Prices, Quotes and Indications
The price of a currency , is called “Quote". There are two kinds of quotes in the Forex market:
+ Direct Quote: the price for 1 US dollar in terms of the other currency, e.g. – Japanese Yen, Canadian dollar, etc.
+Indirect Quote : the price of 1 unit of a currency in terms of US dollars, e.g. – British pound, euro.
The market maker provides the investor with a quote. The quote is the price the market maker will honor when the deal is executed. This is unlike an “indication" by the market maker, which informs the trader about the market price level, but is not the final rate for a deal.
+ Cross rates: any quote which is not against the US dollar is called “cross". For example, GBP/JPY is a cross rate, since it is calculated via the US dollar. Here is how the GBP/JPY rate is calculated:
GBP/USD = 1.7464;
USD/JPY = 112.29;
Therefore: GBP/JPY = 112.29 x 1.7464 = 196.10
Margin
Banks and/or online trading providers need collateral to ensure that the investor can pay in the event of a loss. The collateral is called the “margin" and is also known as minimum security in Forex markets. In practice, it is a deposit to the trader's account that is intended to cover any currency trading losses in the future. Margin enables private investors to trade in markets that have high minimum units of trading, by allowing traders to hold a much larger position than their
account value. Margin trading also enhances the rate of profit, but similarly enhances the rate of loss, beyond that taken without leveraging.
Maintenance Margin
Most trading platforms require a “maintenance margin" be deposited by the trader parallel to the margins deposited for actual trades. The main reason for this is to ensure the necessary amount is available in the event of a “gap" or “slippage" in rates. Maintenance margins are also used to cover administrative costs. When a trader sets a Stop-Loss rate, most market makers cannot guarantee that the stop-loss will actually be used. For example, if the market for a particular counter currency had a vertical fall from 1.1850 to 1.1900 between the close and opening of the market, and the trader had a stop-loss of 1.1875, at which rate would the deal be closed. No matter how the rate slippage is accounted for, the trader would probably be required to add-up on his initial margin to finalize the automatically closed transaction. The funds from the maintenance margin might be used for this purpose.
Leverage
Leveraged financing is a common practice in Forex trading, and allows traders to use credit, such as a trade purchased on margin, to maximize returns Collateral for the loan/leverage in the margined account is provided by the initial deposit. This can create the opportunity to control USD 100,000 for as little as USD 1,000. There are five ways private investors can trade in Forex, directly or indirectly:
• The spot market
• Forwards and futures
• Options
• Contracts for difference
• Spread betting
A spot transaction
A spot transaction is a straightforward exchange of one currency for another. The spot rate is the current market price, which is also called the “benchmark price". Spot transactions do not require immediate settlement, or payment “on the spot". The settlement date, or “value date" is the second business day after the “deal date" (or “trade date") on which the transaction is agreed by the trader and market maker. The two-day period provides time to confirm the agreement and to arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.
Risks
Although Forex trading can lead to very profitable results, there are substantial risks involved: exchange rate risks, interest rate risks, credit risks and event risks. Approximately 80% of all currency transactions last a period of seven days or less, with more than 40% lasting fewer than two days. Given the extremely short lifespan of the typical trade, technical indicators heavily influence entry, exit and order placement decisions.
--------------------
Trading Forex
Components of a Forex deal
A Forex deal is a contract agreed upon between the trader and the market-maker. The contract is comprised of the following components:
• The currency pairs (which currency to buy; which currency to sell)
• The principal amount
• The rate
Time frame is also a factor in some deals, but this chapter focuses on Day-Trading (similar to “Spot" or “Current Time" trading), in which deals have a lifespan of no more than a single full day. Thus, time frame does not play into the equation. Note, however, that deals can be renewed
to the next day for a limited period of time. The Forex deal, in this context, is therefore an obligation to buy and sell a specified amount of a particular pair of currencies at a re-determined
exchange rate.
Forex trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a “spot rate", or just “rate", for short). If an investor had bought 1,000 euros on that date, he would have paid 1,199.00 US dollars. If one year later, the Forex rate was 1.2222, the value of the euro has increased in relation to the US dollar. The investor could now sell the 1,000 euros in order to receive 1222.00 US dollars. The investor would then have USD 23.00 more than when he started a year earlier. However, to know if the investor made a good investment, one needs to compare this investment option to alternative investments. At the very minimum, the return on investment (ROI) should be compared to the return on a “risk-free" investment. Long-term US government bonds are considered to be a risk-free investment since there is virtually no chance of default - i.e. the US government is not likely to go bankrupt, or be unable or unwilling to pay its debts.
Trade only when you expect the currency you are buying to increase in value relative to the currency you are selling. If the currency you are buying does increase in value, you must sell back that currency in order to lock in the profit. An open trade is one in which a trader has bought or sold a particular currency pair, and has not yet sold or bought back the equivalent amount to complete the deal. It is estimated that around 95% of the FX market is speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.
Exchange rate
Because currencies are traded in pairs and exchanged one against the other when traded, the rate at which they are exchanged is called the exchange rate. The majority of currencies are traded against the US dollar (USD), which is traded more than any other currency. The four currencies traded most frequently after the US dollar are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or “the Majors". Some sources also include the Australian dollar (AUD) within the group of major currencies.
+ The first currency in the exchange pair is referred to as the base currency
+ The second currency is the counter currency or quote currency
+ The counter or quote currency is thus the numerator in the ratio, and the base currency is
the denominator.
The exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of euros that 1.2083 USD must be paid to obtain 1 euro.
Spreads
It is the difference between BUY and SELL, or BID and ASK. In other words, this is the difference between the market maker's "selling" price (to its clients) and the price the market maker "buys" it from its clients. If an investor buys a currency and immediately sells it (and thus there is no change in the rate of exchange), the investor will lose money. The reason for this is “the spread". At any given moment, the amount that will be received in the counter currency when selling a unit of base currency will be lower than the amount of counter currency which is required to purchase a unit of base currency. For instance, the EUR/USD bid/ask currency rates at your bank may be 1.2015/1.3015, representing a spread of 1,000 pips (percentage in points; one pip = 0.0001). Such a rate is much higher than the bid/ask
currency rates that online Forex investors commonly encounter, such as 1.2015/1.2020, with a spread of 5 pips. In general, smaller spreads are better for Forex investors since they require a smaller movement in exchange rates in order to profit from a trade.
Prices, Quotes and Indications
The price of a currency , is called “Quote". There are two kinds of quotes in the Forex market:
+ Direct Quote: the price for 1 US dollar in terms of the other currency, e.g. – Japanese Yen, Canadian dollar, etc.
+Indirect Quote : the price of 1 unit of a currency in terms of US dollars, e.g. – British pound, euro.
The market maker provides the investor with a quote. The quote is the price the market maker will honor when the deal is executed. This is unlike an “indication" by the market maker, which informs the trader about the market price level, but is not the final rate for a deal.
+ Cross rates: any quote which is not against the US dollar is called “cross". For example, GBP/JPY is a cross rate, since it is calculated via the US dollar. Here is how the GBP/JPY rate is calculated:
GBP/USD = 1.7464;
USD/JPY = 112.29;
Therefore: GBP/JPY = 112.29 x 1.7464 = 196.10
Margin
Banks and/or online trading providers need collateral to ensure that the investor can pay in the event of a loss. The collateral is called the “margin" and is also known as minimum security in Forex markets. In practice, it is a deposit to the trader's account that is intended to cover any currency trading losses in the future. Margin enables private investors to trade in markets that have high minimum units of trading, by allowing traders to hold a much larger position than their
account value. Margin trading also enhances the rate of profit, but similarly enhances the rate of loss, beyond that taken without leveraging.
Maintenance Margin
Most trading platforms require a “maintenance margin" be deposited by the trader parallel to the margins deposited for actual trades. The main reason for this is to ensure the necessary amount is available in the event of a “gap" or “slippage" in rates. Maintenance margins are also used to cover administrative costs. When a trader sets a Stop-Loss rate, most market makers cannot guarantee that the stop-loss will actually be used. For example, if the market for a particular counter currency had a vertical fall from 1.1850 to 1.1900 between the close and opening of the market, and the trader had a stop-loss of 1.1875, at which rate would the deal be closed. No matter how the rate slippage is accounted for, the trader would probably be required to add-up on his initial margin to finalize the automatically closed transaction. The funds from the maintenance margin might be used for this purpose.
Leverage
Leveraged financing is a common practice in Forex trading, and allows traders to use credit, such as a trade purchased on margin, to maximize returns Collateral for the loan/leverage in the margined account is provided by the initial deposit. This can create the opportunity to control USD 100,000 for as little as USD 1,000. There are five ways private investors can trade in Forex, directly or indirectly:
• The spot market
• Forwards and futures
• Options
• Contracts for difference
• Spread betting
A spot transaction
A spot transaction is a straightforward exchange of one currency for another. The spot rate is the current market price, which is also called the “benchmark price". Spot transactions do not require immediate settlement, or payment “on the spot". The settlement date, or “value date" is the second business day after the “deal date" (or “trade date") on which the transaction is agreed by the trader and market maker. The two-day period provides time to confirm the agreement and to arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.
Risks
Although Forex trading can lead to very profitable results, there are substantial risks involved: exchange rate risks, interest rate risks, credit risks and event risks. Approximately 80% of all currency transactions last a period of seven days or less, with more than 40% lasting fewer than two days. Given the extremely short lifespan of the typical trade, technical indicators heavily influence entry, exit and order placement decisions.
--------------------
Trading Forex
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