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A
Little FOREX History
The
purpose of this article 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. For the purpose of 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 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 all the wordls' 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 in the reach of most investors.
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 normally made up of banks, large institution,
brokers or even the government. 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.
|
Currency |
1989 |
1992 |
1995 |
1998 |
2001 |
|
US
Dollar |
90 |
82.0 |
83.3 |
87.3 |
90.4 |
|
Euro |
. |
. |
. |
. |
37.6 |
|
Japanese Yen |
27 |
23.4 |
24.1 |
20.2 |
22.7 |
|
Pound Sterling |
15 |
13.6 |
9.4 |
11.0 |
13.2 |
|
Swiss Franc |
10 |
8.4 |
7.3 |
7.1 |
6.1 |
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, EuroDollar, Australia Dollar
and New Zealand Dollar. The first currency quoted is called the base currency.
Have a look below for some example.
|
Currency Symbol Currency Pair |
|
EUR/USD |
Euro / US Dollar |
|
GBP/USD |
Pounds Sterling/ US Dollar |
|
USD/JPY |
US
Dollar / Japanese Yen |
|
USD/CHF |
US
Dollar / Swiss Franc |
|
USD/CAD |
US
Dollar / Canadian Dollar |
|
AUD/USD |
Australian Dollar / US Dollar |
|
NZD/USD |
New
Zealand Dollar / US Dollar |
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.
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 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 may 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.
Leverage
Leverage financed with credit, such as that purchased on a margin account is
very common in Forex. A margined account is a leverageable account in which
Forex can be purchased for a combination of cash or collateral depending what
your brokers will accept. The loan(leverage) in the margined account is
collateralized by your initial margin (deposit), if the value of the trade
(position) drops sufficiently, the broker will ask you to either put in more
cash, or sell a portion of your position or even close your position. Margin
rules may be regulated in some countries, but margin requirements and interest
vary among broker/dealers so always check with the company you are dealing with
to ensure you understand their policy.
Up
until this point you are probably wondering how a small investor can trade such
large amounts of money (positions). The amount of leverage you use will depend
on your broker and what you feel comfortable with. There was a time when it was
difficult to find companies prepared to offer margined accounts but nowadays you
can get leverage from a high as 1% with some brokerages. This means you could
control $100, 000 with only $1, 000.
Typically the broker will have a minimum account size also known as account
margin or initial margin e.g. $10, 000. Once you have deposited your money you
will then be able to trade. The broker will also stipulate how much they require
per position (lot) traded. In the example above for every $1, 000 you have you
can take a lot of $100, 000 so if you have $5, 000 they may allow you to trade up
to $500, 00 of forex.
The
minimum security (Margin) for each lot will very from broker to broker. In the
example above the broker required a one percent margin. This means that for
every $100, 000 traded the broker wanted $1, 000 as security on the position.
Margin
call is also something that you will have to be aware of. If for any reason the
broker thinks that your position is in danger e.g. you have a position of
$100, 000 with a margin of one percent ($1, 000) and your losses are approaching
your margin ($1, 000). He will call you and either ask you to deposit more money,
or close your position to limit your risk and his risk. If you are going to
trade on a margin account it is imperative that you talk with your broker first
to find out what their polices are on this type of accounts.
Variation Margin is also very important. Variation margin is the amount of
profit or loss your account is showing on open positions. Let's say you have
just deposited $10, 000 with your broker. You take 5 lots of USD/JPY which is
$500, 000. To secure this the broker needs $5, 000 (1%). The trade goes bad and
your losses equal $5001, your broker may do a margin call. The reason he may do
a margin call is that even though you still have $4, 999 in your account the
broker needs that as security and allowing you to use it could endanger yourself
and him. Another way to look at it is this, if you have an account of $10, 000
and you have a 1 lot ($100, 000) position. That's $1, 000 assuming a (1% margin)
is no longer available for you to trade. The money still belongs to you but for
the time you are margined the broker needs that as security. Another point of
note is that some brokers may require a higher margin at the weekeneds. This may
take the form of 1% margin during the week and if you intend to hold the
position over the weekend it may rise to 2% or higher. Also in the example we
have used a 1% margin. This is by no means standard. I have seen as high as 0.5%
and many between 3%-5% margin. It all depends on your broker.
There
have been many discussions on the topic of margin and some argue that too much
margin is dangerous. This is a point for the individual concerned. The important
thing to remember as with all trading is that you thoroughly understand your
brokers policies on the subject and you are comfortable with and understand your
risk.
Rollovers
Even
though the mighty US dominates many markets most of Spot Forex is still traded
through London in Great Britain. So for our next description we shall use London
time. Most deals in Forex are done as Spot deals. Spot deals are nearly always
due for settlement two business days day later. This is referred to as the value
date or delivery date. On that date the counterparties take delivery of the
currency they have sold or bought.
In Spot
FX the majority of the time the end of the business day is 21:59 (London time).
Any positions still open at this time are automatically rolled over to the next
business day, which again finishes at 21:59. This is necessary to avoid the
actual delivery of the currency. As Spot FX is predominantly speculative most of
the time the trades never wish to actually take delivery of the actual currency.
They will instruct the brokerage to always rollover their position. Many of the
brokers nowadays do this automatically and it will be in their polices and
procedures. The act of rolling the currency pair over is known as tom.next
which, stands for tomorrow and the next day. Just to go over this again, your
broker will automatically rollover your position unless you instruct him that
you actually want delivery of the currency. Another point noting is that most
leveraged accounts are unable to actual deliver of the currency as there is
insufficient capital there to cover the transaction.
Remember that if you are trading on margin, you have in effect got a loan from
your broker for the amount you are trading. If you had a 1 lot position you
broker has advanced you the $100, 000 even though you did not actually have
$100, 000. The broker will normally charge you the interest differential between
the two currencies if you rollover your position. This normally only happens if
you have rolled over the position and not if you open and close the position
within the same business day.
To
calculate the broker's interest he will normally close your position at the end
of the business day and again reopen a new position almost simultaneously. You
open a 1 lot ($100, 000) EUR/USD position on Monday 15th at 11:00 at an exchange
rate of 0.9950. During the day the rate fluctuates and at 22:00 the rate is
0.9975. The broker closes your position and reopens a new position with a
different value date. The new position was opened at 0.9976 a 1 pip difference.
The 1 pip deference reflects the difference in interest rates between the US
Dollar and the Euro. In our example your are long Euro and short US Dollar. As
the US Dollar in the example has a higher interest rate than the Euro you pay
the premium of 1 pip.
Now the
good news. If you had the reverse position and you were short Euors and long US
Dollars you would gain the interest differential of 1 pip. If the first named
currency has an overnight interest rate lower than the second currency then you
will pay that interest differential if you bought that currency. If the first
named currency has a higher interest rate than the second currency then you will
gain the interest differential.
To
simplify the above. If you are long (bought) a particular currency and that
currency has a higher overnight interest rate you will gain. If you are short
(sold) the currency with a higher overnight interest rate then you will lose the
difference.
I would
like to emphasis here that although we are going a little in-depth to explain
how all this works, your broker will calculate all this for you. The purpose of
this book is just to give you an overview of how the forex market works.
Accounts
Although the movement today is towards all transaction eventually finishing in a
profit and loss in US Dollars it is important to realize that your profit or
loss may not actually be in US Dollars. From my observation the trend is more
pronounced in the US as you would expect. Most US based traders assume they will
see their balance at the end of each day in US Dollars. I have even spoken with
some traders who are oblivious to the fact the their profit might have actually
been in Japanese Yen.
Let me
explain a little more. You sell (go short) USD/JPY and as such are short USD and
Long (bought) JPY. You enter the trade at 116.10 and exit 116.90. You in fact
made 80, 000 Japanese Yen (1 lot traded) not US Dollars. If you traded all four
major currencies against the US Dollar you would in fact have made or lose in
EUR, GPY, JPY and CHF. This might give you a ledger balance at the end of the
day or month with four different currencies. This is common in London. They will
stay in that currency until you instruct the broker to exchange the currency you
have a profit or loss into your own base currency. This actually happened to me.
After dealing with mainly US based brokers it had never occurred to me that my
statement would be in anything other than US Dollars. This can work for you or
against you depending on the rate of exchange when you change back into your
home currency. Once I knew the convention I simply instructed the broker to
change my profit or loss into US Dollars when I closed my position. It is worth
checking how your broker approaches this and simply ask them how they handle it.
A small point but worth noting.
It's a
sad fact that for many years the forex market largely remained unregulated. Even
today there are many countries that still don't regulate companies that trade
forex. London has been regulated for many years and the US is now getting its
act together and has also started regulating companies dealing forex. It was
only recently in the US you could with no more than an Internet site and a few
thousand dollars set up your own forex operation and give the impression that
you were larger than you are. I am all for the entrepreneurial flair and
everyone need to start somewhere but when dealing with people's money it is
imperative that the company you choose is solid.
Preferably you want a company that is regulated in the country that it operates,
insured or bonded and has some kind of track recorded. I cannot advise you on
which broker you should use as there are just to many variables to each person,
but as a rule of thumb, nearly all countries have some kind of regulatory
authority who will be able to advise you. Most of the regulatory authorities
will have a list of brokers that fall with their jurisdiction and will give you
a list. They probably wont tell whom to use but at least if the list came from
them you can have some confidence in those companies. Once you have a list give
a few of them a call, see who you feel comfortable with, ask for them to send
you their polices and procedures. If you live near where your broker is based,
go spend the day with him. I have been to many brokerages just to check them
out. It will give you a chance to see their operation and meet their team.
This
brings up another interesting point. When you open an account with a broker you
will have to fill in some forms basically stating your acceptance of their
polices. This can range from a 1 page document to something resembling a book.
Take the time to read through these documents and make a list of things you
don't understand or want explained. Most reputable companies will be happy to
spend some time with you on this. Your involvement with your broker is largely
up to you. As a forex trader you will probably spend long hours staring at the
screen without talking to anyone. You may be the sort of person who likes this
or you may be the sort of person who likes to chat with the dealer in the
trading room. You will normally get a call once a week or once a month from
someone in the brokerage asking if everything is OK.
Statements
Before
we move on to account statements I just want to touch on segregation of funds.
In times past there was a danger that traders who deposited money with their
broker who did not segregate their clients money from their own companies money
were at some risk. The problem arose if the broker misused the deposited funds
to either reinvest or otherwise manipulated these deposits to enhance their own
standing. There were also instances were the broker became insolvent and many
complications ensued as to what was the clients money and what was the broker's
money. With the advent of regulation most broker now segregate their clients
funds from the brokerage funds. Deposits are normally held with banks or other
large financial institution that are also regulated and bonded or insured. This
protects you money should anything happen to your broker. The deposit taking
institution is normally aware that these deposits are client's funds. Depending
on regulation in the particular country you live, each client may have their own
segregated account or for smaller depositors they may be pooled. The point is
that segregation of funds is a safeguard. Ask your broker if your funds are
segregated and who actually has your money.
Just as
with a bank you should are entitled to interest on the money you have on
deposit. Some broker may stipulate that interest is only payable on accounts
over a certain amount but the trend today is that you will earn interest on any
amount you have that is not being used to cover your margin. Your broker is
probably not the most competitive place to earn interest but that should not be
the point of having your money with him in the first place. Payment on your
account that is not being used and segregation of funds all go to show the
reputability of the company you are dealing with.
In this
section I will discuss briefly the basic account statement. I have to keep this
basic as there are as many flavours of account statements as you can imagine.
Just about every broker has their own way of presenting this. The most important
thing is to know where you stand at the end of each day or week. Just because
your broker is Internet based and has all the bells and whistles does not mean
they are infallible. Many of the actions taken before information is imputed are
still done by hand and if humans are involved there will be a mistake at some
point. The responsibility lies with you. It is your money so make sure that all
the transactions are correct.
Normally there is a ticket or docket number to help identify the trade. You will
nearly always find the time and date of the trade. The value date if the
currency were to be delivered. You should always see the direction of the trade,
buy or sell (Long or Short). The amount and rate you bought or sold. Balance to
let you know if you made a profit or a loss. You should also see any open
positions you may have and the margin requirements for that position. A lot of
the more modern systems will show your open position as though it has been
closed just to give you an up to the minute balance.
The
Main Players
Central
Banks And Governments
Policies that are implemented by governments and central banks can play a major
roll in the FX market. Central banks can play an important part in controlling
the country's money supply to insure financial stability.
Banks
A large
part of FX turnover is from banks. Large banks can literally trade billions of
dollars daily. This can take the form of a service to their customers or they
themselves speculate on the FX market.
Hedge
Funds
As we
know the FX market can be extremely liquid which is why it can be desirable to
trade. Hedge Funds have increasingly allocated portions of their portfolios to
speculate on the FX market. Another advantage Hedge Funds can utilize is a much
higher degree of leverage than would typically be found in the equity markets.
Corporate Businesses
The FX
market mainstay is that of international trade. Many companies have to import or
exports goods to different countries all around the world. Payment for these
goods and services may be made and received in different currencies. Many
billions of dollars are exchanges daily to facilitate trade. The timing of those
transactions can dramatically affect a company's balance sheet.
The Man
In The Street
Although you may not think it the man in the street also plays a part in toady's
FX world. Every time he goes on holiday overseas he normally need to purchase
that country's currency and again change it back into his own currency once he
returns. Unwittingly he is in fact trading currencies. He may also purchase
goods and services whilst overseas and his credit card company has to convert
those sales back into his base currency in order to charge him.
Speculators And Investors
We
shall differentiate speculator from investors here with the definition that an
investor has a much longer time horizon in which he expects his investment to
yield a profit. Regardless of the difference both speculators and investors will
approach the FX market to exploit the movement in currency pairs. They both will
have their reason for believing a particular currency will perform better or
worse as the case may be and will buy or sell accordingly. They may decide that
the Euro will appreciate against the US Dollar and take what is called a long
position in Euro. If the Euro does in fact gain ground against the US Dollar
they will have made a profit.
What
Next
Well
now we have a basic understanding of how the FX market works and who the main
players are, what next? You are now going to have to decide the best way to
trade the market. The two most common approaches are that of fundamental
analysis and technical analysis.
Fundamental analysis concentrates on the forces of supply and demand for a given
security. This approach examines all the factors that determine the price of a
security and the real value of that security. This is referred to as the
intrinsic value. If the intrinsic value is below the market price then there is
an opportunity to buy and if the market is above the intrinsic price then there
is an opportunity to sell.
Technical analysis is the study of market action, mainly through the use of
charts and indicators to forecast the future price of a security. There are
three main points that a technical analyst applies. A. Market action discounts
everything. Regardless of what the fundamentals are saying, the price you see is
the price you get. B. The price of a given security moves in trends. C. The
historical trend of a security will tend to repeat.
Of all
of the above things the most important of them is point A. The tools of the
technical analyst are indicators, patterns and systems. These tools are applied
to charts. Moving averages, support and resistance lines, envelopes, Bollinger
bands and momentum are all examples of indicators.
There
are many ways to skin a cat as the saying goes but fundamental and technical
analysis are the two most popular ways of trading FX.
My own
preferred approach is that of technical analysis. It is beyond the scope if this
little book to cover all the finer points of trading and if you would like to
learn more then I would suggest your first book should be ''Trading For
Beginners'' which you can find at tradingforbeginners.com. It is specifically
designed for the novice trader wishing to learn more about trading and technical
analysis.
Conclusion
I hope
you have enjoyed my article introducing you to the Forex market. God Bless and
good trading.
Mark
McRae
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