FX Trading

Until the advent of powerful internet trading software, Forex or FX, was primarily the domain of bank, financial institutions, and multinational corporations. But times have changed. The FX market is now a 24-hour market for almost 7-days a week that does not depend on business hours of foreign exchanges; but rather, it is connected via information technology platforms among global banks which means there is no physical location and no central exchange. Trades constantly negotiate prices between one another with the resulting market bid/ask prices fed into computers and displayed on official quote screens with exchange rates quoted between banks referred to as Inter-bank Rates.

Since, the FX market is decentralized, with activity taking place on a variety of platforms and exchanges, the top of the trading hierarchy are the primary markets, which have historically only been accessible to banks. These primary markets allow banks to offset FX exposures due to their clients' flows as well fulfill their own trading objectives. Relatively recent additions to these secondary markets have been portals, which are online markets where customers can trade FX with one or many banks.

From the first single bank portal introduced in 1996, the market has growth to an average daily turnover [as of April 2007] exceeding US $3.2 trillion, with strong evidence the market is still expanding. Today, prices are instantly tradable because of the advent of powerful internet trading software. This new technology has driven the emergence of another type of FX market - the retail trading platform which is the focus of this overview section.

Because of the size of daily transactional volumes, the FX market is not only stable but extremely liquid. The most liquid currencies in terms of daily turnover are USD and EUR (representing 88.7% and 37.2% respectively.) The only two other currencies in the 2004 BIS survey that represent more than 10% of daily turnover are JPY (20.3%) and GBP (16.9%).

 

What is FX Retail Trading?

Currency is effectively a commodity whose value can change against other currencies, as well as, other assets, such as precious metals and oil. By buying (or selling) a currency, FX Traders look to earn a profit from the movement in the FX currency rate. The beauty of FX is that the cost of trading is also low. This means that retail trades can be transacted for the extreme short-term, literally seconds, as well as, for a longer duration depending upon trader strategy. In an FX transaction, one currency is sold in exchange for another one. The rate expresses the relative value between the two currencies. Currencies are normally identified by a three-digit ‘Swift’ code. For instance, EUR = the euro, USD = the US dollar, CHF = the Swiss franc and so on. Sometimes, EUR/USD is referred to as a “currency pair”. The rate can be inverted. So a EUR/USD rate of 1.5000 is the same as a USD/EUR rate of 0.6666. In other words, $1 is worth €0.6666. The market convention is that most currencies tend to be quoted against the dollar, but there are notable exceptions, such as with the EUR/USD already mentioned. For Example: A trader believes the EUR is about to increase in value against the USD and buys €1 million at 1.5000. Shortly after, the rate is 1.5050 and the trader closes the position for a profit of USD $5,000.

€1,000,000 at 1.50 = US $1,500,000
€1,000,000 at 1.5050 = US $1,505,000
Difference = Profit of US $5,000

Foreign Exchange Rate Systems, Factor that Influence Prices:

There are basically two types of exchange rate systems:

1) Flexible Exchange Rate System, where the currency is ‘free’ to float and its value is determined by market forces and 2) Fixed Exchange Rate System, where the currency is not allowed to fluctuate freely. Instead, its value is fixed either against a single currency, such as the USD, at a specific rate, or a basket of currencies. In a fixed system, the local central bank uses its currency reserves to prevent rate movements.

Since the FX market is a pure market, rates move freely up and down, consequently, there are numerous factors that determine a free floating currency’s worth in the market, from international trade flow, economic and political conditions, and the level of interest rates to simple short-term supply and demand.

There are numerous different types of “participants” in the FX market and frequently they are looking for very different outcomes when they trade. This is why that although FX is often described as a ‘zero-sum’ game – what one investor makes is equal in theory to what another has lost – there are numerous opportunities to make money.

Below is a list of major participants:

As we discussed, one currency is always quoted against another. The “base” currency is the one that can be thought of as the reference. For instance, in a EUR/USD quote, EUR is the base currency and the quote defines how many USD it costs to buy. Similarly, in USD/JPY, USD is the base currency and the rate defines how many JPY it costs to buy. The Bid is the price the market is willing to pay for a certain FX currency pair. The offer, or ask, is the price it is prepared to sell at. For example, in a USD/CHF quote of 1.1650/1.653, the bid is 1.1650, while the offer is 1.1653. Frequently, quotes are abbreviated. In this case, a phone quote would be 50/53. The difference between the bid and the offer is known as the spread.

 

What is a pip?

Pip stands for "percentage in point" and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at $1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. Because the Japanese yen has never been revalued since the Second World War, 1 yen is now worth approximately US$0.08; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of yen, as opposed to 1/1000th with other major currencies).

 

What is carry?

Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K. to name a few.

Currency carry is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

Here's an example of a "yen carry trade": a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar was to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

 

Contract for Difference (CFD)

CFD (Contract for Difference) is a tool that allows you to “derive” equity profit (hence the term “derivatives”) from changes in the price of an underlying asset, no matter whether the price rises or falls, without the need for ownership of the underlying shares.

CFD’s offers the benefits of trading financial instruments such as Equities, Commodities or Treasuries without having to physically own the underlying instrument itself which may be shares, bonds, futures, currencies, commodities, etc. A CFD is a kind of “clone” of the underlying asset allowing investors to take long or short positions, and unlike futures contracts have no fixed expiry date or contract size.

It is an agreement between two parties to exchange the difference between the sell and buy price of a contract, multiplied by the quantity of units of the underlying asset as stipulated in the contract. This instrument is a product of the Over-the-Counter (OTC) market. This instrument appeals to customers with a relatively low deposit who would like to trade in capital intensive markets.

The official definition is that a Contract for Difference (CFD) is an agreement between two parties to exchange the difference between the opening price and the closing price of the contract, at the close of the contract, multiplied by the number of units of the underlying commodity specified within the contract. (If the difference is negative, then the buyer pays instead to the seller.)

Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities. CFDs are currently available in listed and/or over-the-counter markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand and most recently Sweden.

CFDs are no longer permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments. Remember, CFDs are a leveraged product and can result in losses that exceed your initial deposit. CFDs may not be suitable for everyone, so please ensure that you fully understand the risks involved.

The most important advantages of CFDs are:

 

One of the most attractive aspects of trading CFDs is the easily available access to leverage. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. CFDs use the power of leverage to trade which is one of the key reason they are such a powerful tool. CFDs are collateral financed, meaning you only need an initial margin of 1-30% of the total value of the trade to enter the position. For Example: If you wish to enter a position of 1000 BHP Shares at $35 each, usually you would need to front $35,000. Using CFDs, trading on a 5% margin, you would only need an initial deposit of $1,750. An example is the easiest way to show the power of leverage. If you had $1,750 to invest, and wished to purchase BHP at $35 and sell at $37, a standard trade would look as follows:

BUY: 50 x $35 = $1,750
SELL: 50 x $37 = $1,850
PROFIT = $100 or 5.7%

Using the power of leverage the above example reads as follows:

BUY: 1,000 x $35 = $1,750 (5% deposit) + $33,250 (95% borrowed funds)
SELL: 1,000 x $37 = $37,000
PROFIT = $2,000 or 114%

As you can see the profit received after using leverage was far greater than without. It is important to note, that losses are also magnified when using leverage. Furthermore, Commodity markets are very volatile and give an excellent opportunity for CFD traders to make profit out of commodity price movements.

CFD Orders

CFD orders are placed in the same way as placing equity orders. In most cases, a confirmation will be immediate for market orders. Since, the markets are constantly moving during the trading week, it is a good practice to place a “stop loss” on your open position. This allows you to control potential losses in case the market moves against you. There are a number of order types that you can place that facilitate risk management when trading CFDs to control potential profits as well as potential losses on your open positions.

Market Orders

This type of order takes precedence over all other orders. It is an order to buy or sell a CFD contract at the present market price. As long as there is a market for this contract, the order will be filled at the price given to you on the MetaTrader platform.

Limit Orders

This type of order means that a customer sets a limit on price of execution of a trade and it will only be filled at this level. A sell limit order is executed only at the limit price or higher (better), while the buy limit is executed at the limit price or lower (better).

Stop Orders

A stop order is an order which becomes a market order once a certain price level is reached. These orders are often placed to limit the loss on an open position. They also are used to initiate positions. Buy stop orders are placed at a price above the current market price. Sell stop orders are placed below the market price. A buy stop order is activated by a bid or trade at or above the stop price. A sell stop is triggered by a trade or offer at or below the stop price.

Precious & Base MetalsMetals are known as a “commodity” since they have a commerce value that can be traded on an authorized commodity exchange. There are two groups of metals the Precious metals and the Base metals. Precious metals are a group of metals that are highly resistant to corrosion and therefore very valuable. Precious metals include gold, silver, platinum and palladium. Base metals are a group of metals that have a low resistance to corrosion. Base metals include Cooper, Aluminum, Nickel, and Zinc.

Precious metals have many advantages:

Example: Spot Gold

It is 23 February 2010 and you expect the price of gold to fall. Our quote is 995.9/996.4 and you decide to sell 2 contracts at 995.9 (one 100 oz contract equates to $100 per full point). There is no commission to pay on any of our Spot Metals. A few days later, on 26 February, the price of gold has fallen and we are quoting 936.8/937.2. You decide to take your profit, buying 2 contracts at 937.2. Of course, had the market moved in the opposite direction you could have lost more than your initial deposit, but in this example your gross profit is calculated as follows: Profit: 2 contract x $100 per point x 58.7 points = $11,740.

Closing Level 937.20
Opening Level 995.90
Difference 58.70

Note: To calculate the overall result of the transaction you would have to take into account the interest adjustments. Since you have a short position, your account may be either credited or debited to reflect interest adjustments. The interest on your position is calculated daily, by applying the relevant interest rate to the daily closing value of the position.

Margin Trading

The main concept of margin trading is actually rather simple: the fundamental point is that, using leverage, you can trade amounts that significantly exceed your existing funds. For example, to make a transaction for EUR 100,000, a trader does not need to have that amount of money in his or her account. Depending on the degree of leverage, it is enough to use a sum which amounts to only 0.5% of the transaction figure.

In the Forex market, trading is conducted on the difference between a ‘pair’ of currencies. Currency pair quotes show how much secondary currency can be bought or sold for against the base currency. Base currency is the first named currency in a pair. For example, in the currency pair EUR/USD, the base currency is euro. Currency pairs are traded in ‘standard lots’ which generally total 100,000 units of base currency. There are also so-called ‘mini lots’ that make up 10,000 units. To buy one lot per pair EUR/USD, taking into account a market quote of 1.5000, will require only EUR 1,500 or USD $2,250, although the total transaction amount is as high as EUR 100,000.

You can also make a profit on both the rise and fall of currency rates. In forex, it is common for beginner traders to wonder how it is possible to sell euro if there are only US dollars on your account. The answer is that, in making a transaction to sell the currency pair EUR/USD, a trader does not actually conduct a sale but rather, according to the principles of ‘margin’ and ‘full netting’, speculates on a fall in the rate of this currency pair. In order to carry out such a deal, you require an amount of collateral which is determined by the extent of leverage. Instead of an actual exchange of one currency for another, an opposite transaction to the initial (position closing) one occurs, after allowing for profit or loss from the first transaction. The other key concept of margin trading is the obligation to conduct a counter transaction. This procedure is not limited in time, and a trader can conduct such a transaction the same day or even several years later. One advantage unique to the Forex market is that it operates on a 24-hour basis, with no intervals or stops, and does not cease operating in the event of extreme volatility, as, for example, is the case with stock exchanges and commodity markets allowing astute investors to maximize profits during periods of volatility.

Margin Trading System

Involvement of small and medium investors in the Forex market was facilitated by intermediacy of dealing or brokerage companies. Medium and small investors now have access to the global forex market in many nations, using the sums of money starting from $2,000 in their transactions.

A dealing company provides its customers with a credit line – a so-called dealing leverage, or a credit leverage, that is several times as big as the deposit. Brokers providing margin trading services require that a pledge deposit should be contributed, and provide a customer with an opportunity of entering into forex sales and purchase transactions for amounts that are 50, 100 and sometimes even 200 times as large as the deposit made. The risk of losses is borne by the customer; the deposit serves as security hedging a broker. The system of operations through a dealing (brokerage) house, with a credit leverage, was called margin trading.

To put it simply, the essence of margin trading can be reduced to the following: by placing pledged capital, an investor becomes able to manage target loans provided against this pledge and to guarantee indemnification against any potential losses on open forex positions with the deposit. As mentioned above, unlike with forex transactions with actual delivery or actual currency exchange, FOREX participants, especially those with little funds, make use of trading with an insurance deposit - margin trade, or leverage trade.

In case of marginal trade, each transaction must consist of the two stages – purchase/sales of foreign exchange at one price, and then its compulsory sales/purchase at another (or at the same) price. The first action is called the opening of a position; the second is the closing of a position. Opening of a position is not accompanied with actual delivery of foreign exchange, and a participant that opened the position contributes an insurance deposit that serves as guarantee of indemnification against any possible losses. Upon closing of a position, the insurance deposit is returned, and profit or losses are calculated.

Any margin trading transaction must comprise two parts: opening of a position and closing of a position. For instance, when forecasting the euro goes up (looks up) versus the dollar, we want to buy a cheaper euro with dollars now and to sell it back when it rises in price. In this case, the transaction will look as follows: opening of a position – euro purchase; closing of a position – its sale. All the time until the position has been closed we have an “open euro position.” Just the same, when we believe that the euro will cheapen (look down) versus the dollar, our transaction will consist of the following steps: opening a position – sales of a more expensive euro; closing a position – purchase of a cheapened euro. Therefore, we are able to generate profit whether the exchange rate goes up or down. Margin trading appeals by its affordability. Margin trading is free from the said limitations – you can sell and buy depending on your expectations, and 1%-3% of a transaction value will do to enter into the transaction.