The investor's goal in Forex trading is to profit from
foreign currency
However, to know if the investor made a good investment, one needs to compare
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 (i.e. the Trading Platform). The contract is comprised
of the following
components:
•
The currency pairs (which currency to buy; which currency to
sell)
•
The principal amount (or "face", or
"nominal": the amount of currency
involved in the deal)
•
The rate (the agreed exchange rate between the two
currencies).
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 (“rolled-over”)
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
pre-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 1.5000
(this number is also referred to as a “spot rate”, or just
“rate”, for short). If
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an investor had bought 1,000 euros on that date, he would
have paid 1,500.00
US dollars. If one year later, the Forex rate was 1.5100,
the value of the euro
has increased in relation to the US dollar. The investor
could now sell the
1,03300 euros in order to receive 1,510.00 US dollars. The
investor would then
have USD 10.00 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 (also called an “open position”) 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
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selling one unit of the base currency. For example, an
exchange rate for
EUR/USD of 1.5083 specifies to the buyer of euros that
1.5083 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 1.4975/1.5025, representing a spread of 500 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
1.5015/1.5020, 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 (in terms of the counter 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:
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GBP/USD = 2.0000;
USD/JPY = 110.00;
Therefore: GBP/JPY =
110.00 x 2.0000 = 220.00.
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.
Important note:
Easy-Forex™
does NOT require that traders deposit a
maintenance margin. Easy-Forex™ guarantees the exact rate
(Stop-Loss or
other) as pre-defined by the trader.
If you don’t wish to deposit “maintenance margin”, in addition
to the margin
required for trading, join
Easy-Forex™
: no “maintenance margin”, trade
from as little as $100!
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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
•
Please note that this book focuses on the most common way of
trading in the
Forex market, “Day-Trading” (related to “Spot”). Please
refer to the glossary
for explanations of each of the five ways investors can
trade in Forex.
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
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short lifespan of the typical trade, technical indicators
heavily influence
entry, exit and order placement decisions.
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