Forex
The Biggest Market On Earth
Forex is the common word used for Foreign Exchange, and is sometimes referred to as FX or Currencies. In the Futures markets currencies are bought and sold like any other commodity, but in the FX market, they are exchanged with each other, hence the term Foreign Exchange Market. This post will look at the Foreign Exchange Market.
If I am in Australia and I wish to buy US dollars, I will sell AU Dollars in order to do so. Therefore, I become a participant in the FX market. FX participants vary and may include tourists, shop owners, tellers, importers and exporters, banks and other financial institutions, fund managers, traders and investors. The FX market is open 24 hours a day and starts in New Zealand at 9am Monday morning their time and finishes the week in New York at 5pm Friday EST.
There are several ways FX is exchanged, such as spot, forwards, options and so on. Importers and Exporters for example, will use forwards or options as a hedge or as a way to lock in a FX rate now, rather than take the risk of adverse movements in FX rates between now and the future. Speculators mostly trade spot FX, and as such will be discussed.
Spot transactions are simply the simultaneous exchange of one currency for another. For example, to trade the EUR/USD pair, you are dealing with two currencies, the Euro, and the US Dollar. If you buy the EUR/USD pair, you are in fact buying the Euro in US dollars, and as such are selling US Dollars. If you sell the EUR/USD pair, you are selling the Euro and receiving US Dollars in exchange. The following FX pairs are traded the most; EUR/USD (Euro/US Dollar), USD/JPY (US Dollar /Japanese Yen), GBP/USD (British Pound or Sterling/ US Dollar), AUD/USD (Aussie Dollar/ US Dollar), USD/CHF (US Dollar /Swiss Franc) and USD/CAD (US Dollar /Canadian dollar or Loonie)
FX rates are represented by a number, such as 1.3500 (the EUR/USD pair), where the first currency of the pair is the base currency, i.e. represented by one (1), and the second currency is the ‘terms’ or counter currency. What this number tells you is that it will take 1 Euro to buy 1.35 US Dollars, or if I wanted to buy 1 Euro, I would need 1.35 US Dollars. If the FX rate for the USD/CAD is 1.1100, it will take 1 US dollar to buy 1.11 Canadian Dollars, or if I wanted to buy 1 US Dollar, it would take 1.11 Canadian Dollars.
There is also what’s called a spread, i.e. an offer and a bid, and at any given time if the EUR/USD is trading at 1.3500, this will be the offer (sell price), and the bid (buy price) will be slightly higher, such as 1.3503. The difference is called the spread in pips; pip stands for price interest points and is how the broker makes their commission. So if you did buy the EUR/USD pair whilst it was trading at 1.3500, you are actually buying it at 1.3503, and as such if you were to immediately sell it back to the market at 1.3500, you will lose 3 pips.
FX is traded in Lots, which is a standardized trading unit equivalent to 100000 of the base currency, but brokers offer leverage to allow you to trade a lot with only 1%. But in recent times brokers have introduced mini-lots which are in effect 1/10th the size, therefore allowing you to control $10,000 lots with only a $100 margin. To demonstrate how lots, leverage, pips and commissions are all connected let’s do an example trade.
Fundamentally, if I believe the Euro is undervalued short-term, and at the same time, I feel the US Dollar is overvalued short-term, technically or on a chart, this would indicate that I think the EUR/USD should appreciate, or head up. Just like trading stocks, if I believe it is going up I buy or go long.
I would like to trade one lot, so I will be buying Euros with US dollars (or simply put going long the EUR/USD pair). What this means is that I am buying 100,000 Euros with $135,000 US Dollars. Because my broker offers leverage of 100:1, I am able to control this trade with only $1350 US Dollars (if your account is in another currency for e.g., Australian dollars, your broker will convert this for you but may not make it obvious, either way you need to know what the margin requirement is in Australian dollars in order to understand if you have enough. In this instance I would simply divide the $1350 by the current AUD/USD rate and this would tell me how much of my Australian dollars I am required to have as margin).
The EUR/USD pair is trading at 1.3500 and the spread applied by the broker is 3 pips, so this means I will actually be paying 1.3503 for this trade, or $135,030 for the lot. My cost for this trade is then US$30 ($135,030 - $135,000).
If it advances to 1.3520, then my 100,000 Euros is now worth $135,200 US Dollars. I can sell my Lot and I’ll receive $135,200 US Dollars in return, and as such have made a profit of $200, less $30 equaling $170 US Dollars.
It’s important you understand the value of a pip. The easiest way to do this is if the ‘terms’ (second) currency is US dollars, then for every lot you trade your pip will be worth $10. If however the US Dollar is the base currency (for e.g. USD/CHF), the pip value is calculated by dividing the rate into 10. So if we use the USD/CHF pair which may be trading at 1.2000, then 10/1.2000 equals 8.3333, which means your pip is worth $8.3333 for every lot you trade.
The reason it’s important to know your pip value is so that you can work out your risk. If I risk 100 pips on the EUR/USD I am risking $1000, but risk 100 pips on the USD/CHF pair and I’m actually only risking $833.33.
To work out your margin requirement, it is simply 1% of the US component. If the USD is the base currency it will always be $1000 for every lot. If the USD is the counter currency, it will be 1% of the amount in US Dollars required to buy the base currency (which is why our example trade required $1350 US Dollars as margin).
If you have any other questions on Forex please ask.
Happy Trading
Dean Whittingham
Elite Insiders Group - Trading Systems
Financial Market Fisherman © 2004 - 2007
