Forex Trading – Market Basics and Overview


issy resizedIt is important to understand how the market works, why it is such a good market to trade on and how prices are quoted. In addition to being the largest financial market it is also the most liquid.

Liquidity is important as it means that buyers and sellers are matched very easily in the market. Every single day there is a turnover in excess of 1.5 trillion dollars. If a market is not liquid you may not get some-one to oppose your trade. The Forex market is so liquid you would be able to place a trade every second of a day. But what is very important is that it is a 24 hour market 5 days a week and only closes on week ends. Being a 24 hour market it allows traders to trade when it is suitable for them. If you have a day job you could come home in the evening and trade, a big advantage

Around the world, trading hours overlap as some financial markets close and others open for trading. Trading takes place in New York, London, Hong Kong, Singapore, Frankfurt, Tokyo, and many other financial markets. These financial markets are linked to one another in a unified market, so at any given time one or more financial markets are open for currency trading.

But as far as we are concerned the market trades in 3 main sections.

It starts in Tokyo round midnight and runs to about 7 am when London takes over. The London session will run into mid afternoon when the US takes over the market to the end of their day after which the Tokyo market again comes on stream. There is controversy about when the different sessions take over but it is of no real consequence. What is significant is that the Tokyo session is the least active and the London session the most active with the US in between. Because the London session is the most active the biggest moves very often takes place in this session. For this reason many Americans wake up early to trade during this session around 12 noon London time. This means that US traders would start trading as early as 6 a.m. US time.

For day traders, the currency market provides an alternative to stock market and futures trading. A trader only has a few major currencies to trade (the Dollar, Euro, Yen, British Pound, Swiss Franc, Canadian and Australian dollar are the most popular), whereas he is faced with tens of thousands of stocks to choose from in the different bourses.

 

Currency trading also provides greater leverage than stocks and futures, and the minimum investment required to open a currency trading account is much lower. All of these advantages compounded managed-forex-marketswith the ability to choose flexible trading hours, has resulted in many equity and futures traders deserting the stock market to trade currencies. The decision to go long or short on a currency is much simpler than on an equity. It is a 50/50 call, up or down, in a very liquid market with a short time frame. Taking profits can occur in a few hours.

Trading equities have more factors than currencies that will influence its direction with the direction of the overall market influencing the movement of individual stocks. Not so with trading Forex. Now currencies are traded in pairs so a typical quote would be the Euro/USD. You are buying and selling a pair simultaneously and this takes place automatically.

There are many currencies in the world but as a trader we focus on the main currencies just mentioned, namely the USD, EURO, GBP, Swiss Franc, Japanese Yen, Canadian and Australian dollar. 75% of trading takes place in these major currencies.

So to sum up, the London session is the most active. In the UK the GBP/USD would be the most active pair to trade and elsewhere probably the Euro/USD. Traders generally concentrate on both these pairs.


The Currency Spot Market

 

A currency spot trade is the most popular transaction in the world. The spot rate is the current market price or cash rate for a currency pair.

 


Bid and Ask

 

When trading currencies, the trader sees two prices: a “bid” and “ask”. This is the same as in stocks and futures. The “bid” is the price a bank or market maker is willing to pay for the currency. The “ask” is the price at which the market maker or bank is willing to sell the currency at. The online currency trader could then, buy from the bank or market maker at the “ask” and sell at the “bid.”

The difference between the bid and ask price is called the spread. The more liquid or active the currency is, the lower the spread. Since the level of liquidity in the major currencies like the EUR/USD, USD/JPY, GBP/USD, and USD/CHF, is so great, the spreads are very tight. The reasons for this is that there are trades being made every few seconds creating liquidity, meaning there will always be a buyer for every seller.

 


Currency Quotes – Base Currency and Counter Currency

 

A currency trade involves two currencies: the base currency and counter currency. In a currency quote the base currency is displayed first followed by the counter currency; for example, EUR/USD. For this currency pair, the base currency is the Euro and the counter currency is the US Dollar. The base currency is always equal to one.

The exchange rate provides the price of the base currency relative to the counter currency; i.e., how much is one Euro (base currency) worth in US Dollars (counter currency)?

Say we have a standard currency quote of 1.7565 which means if we were trading GBP/USD it would mean that one British pound is equal to 1.7565 USD.

The quote refers to the second currency to which the base currency has been compared to.

So if the currency quote for EUR/USD was 1.2048 / 52, this would mean that if a currency trader was buying, he would pay 1.2052 Euro for 1 dollar and he would receive 1.2048 Dollars for each Euro when selling. When the exchange rate rises, it means the base currency is getting stronger against the counter currency. When the exchange rate falls, the opposite is true.

 


 “PIPS”

 

This is a term we must fully understand. If we make Pips we make money and if we lose pips we lose money. “Pip” stands for “price interest point” in the currency market, and it represents the smallest fluctuation in price for a given currency pair.

If we make 10 pips and the original quote was 1.7565 it would mean that the final quote would be 1.7575. The pips are added to the furthest right hand side of the quote.

If we made 5 pips it would go to 1.7570

If we made 200 pips the quote would go to 1.7765

So we are concerned with the numbers after the decimal point.

So for most currencies the exchange rate is carried out to the fourth decimal place. In this case, a pip is 1/10,000th of the counter currency or 0.0001.

For example if the Ask price in the EUR/USD is 1.2048 and it goes up 1 pip, the resulting rate will be 1.2049. Some exchange rates, like the dollar – yen, are only carried out to two decimal points. For these currency pairs, a pip is worth 1/100th of the counter currency.

To make the point again one of the advantages of currency trading over stock trading is simplicity. A currency trader could concentrate on a few extremely liquid currencies rather than worrying about thousands of stocks to choose from. For that reason, a novice trader should use this to his advantage and concentrate on one or a few of the major currencies.

 


Currency Trading vs Investing

 

There is a very big difference between trading and investing. Currency trading is not investing. It is considered speculation (like day trading stocks). Every portfolio requires a certain portion of speculation and investments. With the low minimum required ($3,000 for a standard account / $300 for a mini account) for trading currencies, online currency trading can be the perfect tool to deal with the speculative portion of any portfolio.

Currency trading is short-term in nature. A day trader buying euros versus the dollar is not trying to predict what is going to happen to the euro in the next 10 years. He is concerned with the price fluctuations after he enters a position. His goal is for the euro to appreciate in value as soon as possible after his purchase.

Currency trading, if performed correctly, is a form of controlled speculation, where the chances of success are good when the trader treats it as a business and dedicates his time to learn the required skills to increase his chances of success.

Before a currency trader starts trading, he needs to understand how the currency market works, how to operate his trading software, and how to apply cycle and technical analysis to the currency pairs he is trading.

 


Currency Trading on Margin

 

One of the tremendous advantages of currency trading is the huge leverage traders have at their disposal. Trading on margin means that the trader does not need to deposit the entire amount of the transaction. A portion of the value of the transaction is provided by the brokerage firm where the trader opened his account.

For equities, the margin requirement is 25% for positions that are entered and closed during the day and 50% for positions carried overnight (from one trading day to another). That means that a trader only needs to deposit 25% or 50% of the value of the trade respectively. Consequently, the leverage enjoyed by stock traders can be from 2:1 to 4:1.

How does the margin requirement for currency trading compare to equity trading? To trade currencies, the margin requirement is only 1%. That means that a currency trader only needs to deposit $1,000 for every $100,000 of currency traded.

Thus, the leverage is 100:1, much greater than for equity trading. A leverage of 100 to 1 means that every 1% move in the value of the foreign currency exchange rate gets multiplied one hundred times.

Even though the minimum margin requirement with Currency Trading is 1%, the currency trader does not have to take advantage of the entire amount of leverage he has available. The greater the leverage used, the more speculative the trading becomes. The amount of leverage the currency trader should use depends on his risk tolerance and on his desire to take risk.

No matter what the amount of leverage that the trader decides to use is, clients who open accounts will not have debit balance risk; that is, a client can never lose more than he deposits in his account.

 


Types of Orders in Currency Trading

 

These are the orders that can be placed when trading currencies online or on the phone.

 


Market Orders

 

A market order is an order to buy or sell a currency at the current market price. When placing a market order, the currency trader specifies the currency pair he wants to buy or sell (EUR/USD, USD/JPY, etc.) and the number of lots he is interested in buying or selling. The currency trader will pay the Ask price when buying and the Bid price when selling.

A market order is the easiest and simplest order to place when trading currencies online. With FXCM’S single-click online currency trading platform, to buy, the trader will simply click a button labelled “BUY” and to sell, a button labelled “SELL.” Thus, with a single click of the mouse button, a currency trader can buy and sell currencies almost instantly.

When placing a currency market order over the phone, the same situation described above applies. A trader will ask the dealer to buy or sell a specific number of lots of a given currency after obtaining a two-way quote from the dealer.


Limit Orders

 

A limit is an order to buy or sell a currency at a specified price or better. In a limit order, the currency trader not only specifies which currency he wants to buy or sell, but also at which price he wants to do so. For example, if a trader places a limit order to buy 2 lots of EUR/USD at 1.2110, the order could only be executed at an exchange rate equal to 1.2110 or lower (which is better for a buyer).

When placing a limit order, the trader also specifies the duration for which the order is to remain active while it is not executed.

 


Stop Orders

 

The stop order (also known sometimes as the stop loss order) is an order that is activated when a specified price is reached. A stop order becomes a regular market order when the exchange rate reaches a specified level. Stop orders can be used to enter the market on momentum or to limit the potential loss of a position.

Stop orders are extremely important in foreign currency trading and should be used by all traders that want to participate in the currency markets. Just like for limit orders, when placing a stop order a trader must specify for how long that order is to remain active.

 

Example of using a stop order to protect a position:

 

A currency day trader buys 100,000 (1 lot) of EUR/USD at 1.2305 in anticipation of an expected 80 pip rally in the euro. In order to protect himself from an unmanageable loss, the trader places a stop loss order 1.2285 (20 pips below the current price). This way, if the euro drops instead of rises against the dollar, the trader’s loss is limited to 20 pips ($200).

This will be dealt with in more detail in the chapter on Money Management.

 


Currency Trading Examples

 

All currency trades involve the buying of one currency and the selling of another, simultaneously. Currency quotes are given as exchange rates; that is, the value of one currency relative to another. The value of the exchange rate in the currency market is determined by the relative supply and demand of both currencies.

When a currency trader places a trade he wants the currency purchased to appreciate in value versus the currency sold. His ability to determine the direction that the exchange rate will move, will dictate his gain or loss in a FOREX transaction. Let’s do an example with a currency quote obtained from the currency trading system.

Example of a currency trade

The current bid-ask price for EUR/USD is 1.2120/1.2123, meaning you can buy 1 euro (EUR) for 1.2123 US dollars (USD).

Suppose you feel that the EUR will appreciate in value against the dollar. To execute this strategy, you would buy Euros with dollars and then wait for the exchange rate to rise.

So you make the trade: purchasing 100,000 EUR (1 lot) at 1.2123 (121,230 Dollars). (Remember, at 1% margin, your initial margin deposit would be 1,000 Euros or 1,212.30 USD.) Automatically you set a stop loss of 30 pips in case the Euro goes down, by placing a sell stop order at 1.2096. Having a stop loss in place when trading currencies is extremely important, in case the currency bought or sold goes against you.

Although no one likes to take a loss, placing stop losses in currency trading is part of smart money management and will play a big role in improving a currency trader’s potential for success. The example shown here of a 30 pip stop loss is completely arbitrary and should by no means be used in every currency transaction.

As you expected, EUR/USD rises to 1.2236/39. Now you must sell Euros for Dollars to realize any profit. You can now sell 1 EUR for 1.2236 Dollars. When you sell the 100,000 Euros at the current EUR/USD rate of 1.2236, you will receive 122,360 USD.

Since you originally sold (paid) 121,230 USD, your profit is US $1130.

Total profit = US $1130.00 (113% return on an initial margin deposit of 1,000 Euros)