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The Forex Market
Forex Market Background
The global marketplace has changed dramatically over the past several years. New investment strategies are becoming more important in order to minimize risk, as well as to maintain high portfolio returns. Among the most rewarding of the markets opening up to traders is the Foreign Exchange market. Identifiable trading patterns, as well as comparatively low margin requirements, have rewarding trading opportunities for many.
In contrast to the world's stock markets, foreign exchange is traded without the constraints of a central physical exchange. Transactions are instead conducted via telephone or online. With this transaction structure as its foundation, the Foreign Exchange Market has become by far the largest marketplace in the world. Average volume in foreign exchange exceeds $1.5 trillion per day versus only $25 billion per day traded on the New York Stock Exchange. This high volume is advantageous from a trading standpoint because transactions can be executed quickly and with low transaction costs (i.e., a small bid/ask spread).
As a result, foreign exchange trading has long been recognized as a superior investment opportunity by major banks, multinational corporations and other institutions.
Spot foreign exchange is always traded as one currency in relation to another. So a trader who believes that the dollar will rise in relation to the Euro, would sell EURUSD. That is, sell Euros and buy US dollars. We have compiled the following guide for quoting conventions:
| Symbol |
Currency Pair |
Trading Terminology |
| GBPUSD |
British Pound / US Dollar |
"Cable" |
| EURUSD |
Euro / US Dollar |
"Euro" |
| USDJPY |
US Dollar / Japanese Yen |
"Dollar Yen" |
| USDCHF |
US Dollar / Swiss Franc |
"Dollar Swiss", or "Swissy" |
| USDCAD |
US Dollar / Canadian Dollar |
"Dollar Canada" |
| AUDUSD |
Australian Dollar / US Dollar |
"Aussie Dollar" |
| EURGBP |
Euro / British Pound |
"Euro Sterling" |
| EURJPY |
Euro / Japanese Yen |
"Euro Yen" |
| EURCHF |
Euro / Swiss Franc |
"Euro Swiss" |
| GBPCHF |
British Pound / Swiss Franc |
"Sterling Swiss" |
| GBPJPY |
British Pound / Japanese Yen |
"Sterling Yen" |
| CHFJPY |
Swiss Franc / Japanese Yen |
"Swiss Yen" |
| NZDUSD |
New Zealand Dollar / US Dollar |
"New Zealand Dollar" or "Kiwi" |
| USDZAR |
US Dollar / South African Rand |
"Dollar Zar" or "South African Rand" |
| GLDUSD |
Spot Gold |
"Gold" |
| SLVUSD |
Spot Silver |
"Silver" |
Spot Forex versus Currency Futures
Many traders have made the switch from currency futures to spot foreign exchange ("forex") trading. Spot foreign exchange offers better liquidity and generally a lower cost of trading than currency futures. Banks and brokers in spot foreign exchange can quote markets 24 hours a day. Furthermore, the spot foreign exchange market is not burdened by exchange and NFA ("National Futures Association") fees, which are generally passed on to the customer in the form of higher commissions. For these reasons, virtually all professional traders and institutions conduct most of their foreign exchange dealing in the spot forex market, not in currency futures.
The mechanics of trading spot forex are similar to those of currency futures. The most important initial difference is the way in which currency pairs are quoted. Currency futures are always quoted as the currency versus the US dollar. In Spot forex, some currencies are quoted this way, while others are quoted as the US dollar versus the currency. For example, in spot forex, EURUSD is quoted the same way as Euro futures. In other words, if the Euro is strengthening, EURUSD will rise just as Euro futures will rise. On the other hand, USDCHF is quoted as US dollars with respect to Swiss Francs, the opposite of Swiss Franc futures. So if the Swiss Franc strengthens with respect to the US dollar, USDCHF will fall, while Swiss Franc futures will rise. The rule in spot forex is that the first currency shown is the currency that is being quoted in terms of direction. For example, quot;EUR" in EURUSD and "USD" in USDCHF is the currency that is being quoted.
The table below illustrates which spot currencies move parallel to the futures contract and which move inversely (opposite):
| Forex Symbol |
Currency Pair |
Futures Symbol |
Directional Relationship |
| GBPUSD |
British Pound / US Dollar |
BP |
Parallel |
| EURUSD |
Euro / US Dollar |
EU |
Parallel |
| USDJPY |
US Dollar / Japanese Yen |
JY |
Inverse |
| USDCHF |
US Dollar / Swiss Franc |
SF |
Inverse |
| USDCAD |
US Dollar / Canadian Dollar |
CD |
Inverse |
| AUDUSD |
Australian Dollar / US Dollar |
AD |
Parallel |
| NZDUSD |
New Zealand Dollar / US Dollar |
ND |
Parallel |
Entering Trades
Trades can be initiated in one of three ways:
1) a Market Order
2) a Stop
3) a Limit
1) Market Order
Placing a market order means that you will buy at your brokers current "ask" price, or sell at your brokers current "bid" price, whatever that price currently is. For example, suppose you are buying EURUSD. The current market, as quoted by your broker or on GCI's "Dealing Rates" window, is .9152/56. This means that your broker is willing to buy EURUSD from you at .9152, and sell it to you at .9156.
2) Stop Order
Initiating a trade with a stop order means that you will only have a position if the market moves in the direction you are anticipating. For example, if USDJPY is currently 128.50 and you believe it will move higher, you could place a "buy stop" at 128.60. This means that the order will only be filled if the market moves up to 128.60. The advantage is that if you are wrong and the market moves straight down, you will not have bought (because 128.60 will never have been reached). The disadvantage is that 128.60 is clearly a less attractive rate at which to buy than 128.50. Initiating a trade with a Stop order is usually appropriate if you wish to trade only with strong market momentum in a particular direction.
3) Limit Order
A Limit order is an order to buy below the current price, or sell above the current price. For example, if EURUSD is trading at .9152/56 and you believe the market will rise, you could place a limit order to buy at .9145. If filled, this will give you a long position in EURUSD at .9145, which is 11 pips better than if you had just bought EURUSD with a market order. The disadvantage of this Limit order is that if EURUSD moves straight up from .9152/56, your limit at .9145 will never be filled and you will miss out on the profit opportunity even though your view on the direction of EURUSD was correct. Entering a trade with a Limit order is usually appropriate if you believe that the market will remain in a range before moving in your anticipated direction, allowing the order to be filled first.
Exiting Trades
As with entering trades, exiting trades can be done with either a "Market" order, a "Limit" order, or a "Stop" order. "Trailing Stops" are variations of stops and can also be used effectively to exit trades. Exiting trades will generally result in a loss or a gain on an open position, and should be done once you have reached your profit target, your maximum loss, or when your market view has changed.
1) Exiting with a Market Order
Exiting a trade with a market order means that you will sell at your brokers current "bid" price, or buy at your brokers current "ask" price, whatever that price currently is. For example, suppose you had purchased one lot of USDJPY, meaning you are long one lot. If you then assume that the current market is 127.51/55, you know that you can exit your existing long position at 127.51 (that is, sell it to close at 127.51).
2) Exiting with a Stop
Exiting a trade with a stop order means that your position will be closed after an adverse market move of a specified amount. This does not necessarily mean that you have incurred a loss on the trade (see "trailing stops" below). For example, if you had purchased 1 lot of USDJPY and it is now trading at 128.50/54, you could place a Stop at 128.20. This means that the order will only be filled if the market moves down to 128.20, limiting your loss to .30 (30 pips).
A Trailing Stop is placed in the same manner, but the concept here is that the stop will be moved as the market moves in your favor (the stop "trails" the market"). So for example, assume that you had placed your stop at 128.20 with a long USDJPY position at 128.50. If USDJPY moves up to 128.90, you could then move the stop up to 128.60. This would ensure a worse case of a gain of .10 (10 pips), while still allowing unlimited upside if USDJPY continues to rise.
The advantage of exiting with a Stop is that (1) you limit your downside to the amount you specify with your stop, and (2) you have unlimited upside in the event that the market continues to move in your favor. The disadvantage is that markets will occasionally move adversely initially, causing your stop to be filled and closing your position, and then proceed to move in the direction that you had originally anticipated.
3) Exiting with a Limit Order
Exiting a trade with a limit order is an effective way to ensure that you will capture profits once your profit target is reached. The advantage of exiting a trade with a limit order is that your position will be successfully closed if your profit target is reached, even if only for a few seconds. For example, if you purchased USDJPY at 128.50 and placed a limit order to exit the trade at 129.50, you will successfully capture a 1.00 profit (100 pips) if 129.50 is reached even briefly and then the market falls again. The disadvantage is that you will limit your upside, foregoing additional gains if the market was to continue to move in your favor. Furthermore, you will not limit your downside if the market moves against you. For example, if the market rises to 132.00, your profit will still be limited to the 100 pips because your position was closed at 129.50. If the market moves down below 128.50, your losses will not be limited, unless you had also placed a stop on the open position (see "exiting with a Stop" above.
Using Stops and Limits Together. A common strategy is to place both a Stop and a Limit on the same open position. On the GCI system, the position will be closed by whichever order is reached first, and the other order will automatically be cancelled. This is known as "OCO" or "One Cancels the Other".
Controlling Risk
Controlling risk is one of the most important ingredients of successful trading. While it is emotionally more appealing to focus on the upside of trading, every trader should know precisely how much he is willing to lose on each trade before cutting losses, and how much he is willing to lose in his account before ceasing trading and re-evaluating.
Risk will essentially be controlled in two ways: 1) by exiting losing trades before losses exceed your pre-determined maximum tolerance (or "cutting losses"), and 2) by limiting the "leverage" or position size you trade for a given account size.
Fundamental Trading
Fundamental trading strategies consist of macro, strategic assessments of where a currency should be trading based on virtually any criteria but the price action itself. These criteria often include the economic condition of the country that the currency represents, monetary policy, and other "fundamental" elements. SEE OUR ECONOMIC DATA PAGE
Fundamental analysis alone is often difficult to use when dealing with currencies, commodities and other "margined" products. This is because fundamental analysis does not provide for specific entry and exit points, and therefore makes it difficult to control risk when using leverage.
Technical Analysis
Technical Analysis is probably the most common and successful means of making trading decisions and analyzing forex and commodities markets. Technical analysis differs from fundamental analysis in that technical analysis is applied only to the price action of the market, ignoring fundamental factors. As fundamental data can often provide only a long-term or "delayed" forecast of exchange rate movements, technical analysis has become the primary tool with which to successfully trade shorter-term price movements, and to set stop loss and profit targets. Technical analysis consists primarily of a variety of technical studies, each of which can be interpreted to generate buy and sell signals or to predict market direction. Please see our TECHNICAL STUDIES PAGE for a detailed description of these studies and their uses.
Margin Requirements
Forex and commodity trading is always conducted on "margin". This means that a cash deposit, usually much smaller than the underlying value of the currency or commodity contract, is required in order to trade. For example, a broker might require only $1,000 in the trader's account in order to trade a $100,000 currency position. The $1,000 is referred to as "margin". This amount is essentially collateral to cover any losses that you might incur. Since nothing is actually being purchased or sold for delivery, the only requirement, and indeed the only real purpose for having funds in your account, is for sufficient margin. Margin should reflect some rational assessment of potential risk in a position. For example, if a currency is very volatile, a higher margin requirement would normally be justified. One common rule of thumb is a worst-case one day move in the market. So if a $100,000 currency position is unlikely to move by more than 1% (or $1,000) in a 24 hour period, a $1,000 margin requirement is probably reasonable. If, however, the currency or commodity in question is highly volatile and is likely to move by, say, $3,000 or more it would put the broker at increased credit risk to require only a $1,000 margin deposit.
Note that margin available in your trading account is based on account equity, not account balance. The equity is the most accurate measure of the value of your account, as it takes into account unrealized gains or losses
Overnight Interest (Premium)
Every currency and commodity has a "cost of carry" associated with holding the position for more than one day. In currencies, this cost is a function of the "interest rate differential" of the two currencies that comprise the exchange rate.
For example, in USDJPY, the interest rate differential is the difference between short-term U.S. interest rates and short-term Japanese interest rates. If, for example, U.S. interest rates are 5.0% and Japanese interest rates are 1.0%, the interest rate differential is 4.0% (5.0% - 1.0%). This means that if a trader was to sell USDJPY, he would have to pay 4.0% of the notional amount of the contract per year to hold the position. On one lot, the notional amount is $100,000, so the trader would have to pay approximately $4,000 to hold the position for one year. This translates to approximately $11.00 per day per lot for holding the USDJPY position ($4,000/365).
How to Calculate Pip Values
A "pip" is the smallest increment in any currency pair. In EURUSD, a movement from .8941 to .8942 is one pip, so a pip is .0001. In USDJPY, a movement from 130.45 to 130.46 is one pip, so a pip is .01. How much in dollars is this movement worth, for example, per 10,000 Euros in EURUSD? How much is one pip worth per 10,000 Dollars in USDJPY? We will refer to the size, in this case 10,000 units of the base currency, as the "Notional Amount". The formula for calculating a pip value is therefore:
(one pip, with proper decimal placement/currency exchange rate) x (Notional Amount)
Using USDJPY as an example, this yields:
(.01/130.46) x USD10,000 = $0.77
or 77 cents per pip
Using EURUSD as an example, we have:
(.0001/.8942) x EUR10,000 = EUR 1.1183
But we want the pip value in USD, so we then must multiply EUR1.1183 x (EURUSD exchange rate):
EUR 1.1183 x .8942 = $1.00
This is in fact a phenomenon you will see with any currency in which the currency is quoted first (such as EURUSD, GBPUSP, or AUDUSD): the pip value is always $1.00 per 10,000 currency units. This is why pip (or "tick") values in currency futures, where the currency is quoted first, are always fixed.
Approximate pip values for the major currencies are as follows, per 10,000 units of the base currency:
USD/JPY: 1 pip = $.77; In other words a change from 130.45 to 130.46 is worth about $.77 per $10,000.
EUR/USD: 1 pip = $1.00; .8941 to .8942 is worth $1.00 per 10,000 Euros.
GBP/USD: 1 pip = $1.00; 1.4765 to 1.4766 is worth $1.00 per 10,000 Pounds.
USD/CHF: 1 pip = $.59; 1.6855 to 1.6866 is worth $.59 per $10,000.
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