Forex Basics

Abbreviations of currencies and nicknames of some major pairs

ISO Currency Codes

Currency Pair Terminology

US DollarUSD
EuroEUR
British PoundGBP
Japanese YenJPY
Swiss FrancCHF
Canadian DollarCAD
Australian DollarAUD
New Zealand DollarNZD

Euro DollarEUR/USD
CableGBP/USD
SwissyUSD/CHF
LoonieUSD/CAD
Dollar YenUSD/JPY
Aussie DollarAUD/USD
Kiwi DollarNZD/USD

Forex Quotes:

All forex price quotes include the bid and the ask price. A bid is a price at which a market maker is willing to buy a currency (at which the trader is willing to sell), and an ask is a price at which a market maker is willing to sell a currency (at which the trader is willing to buy). When you trade, you simultaneously buy one currency and sell the another. The first currency unit in the pair is known as the base currency, and the second currency is the “counter” or “terms” currency. Some examples of forex quotes are shown on the right.

EUR/USD1.28071.2810
USD/CHF1.22361.2240
GBP/USD1.84441.8448


The quote on the left-hand side is the bid, whereas the one on the right-hand side is the ask. As you can see, the ask is always higher than the bid, and the difference, which is called the spread, is where the market maker makes its money from.In the example of the EUR/USD quote above, the spread is 3 pips (One pip refers to a movement of one in the last decimal point in the currency pair). The spread should be considered as part of your transaction cost. It is recovered when your trade moves favourably by the spread amount.

Based on the USD/CHF example quote above, you can sell US$1 for Sfr 1.2236 according to the bid price, or you can buy US$1 for Sfr 1.2240 according to the ask price. If you are buying USD/CHF to go long, you are buying US dollar, and are at the same time selling the Swiss Franc. If you are selling USD/CHF to go short, then you are selling US dollar, and at the same time buying the Swiss Franc.

Calculating Values:

Face Value

In some forex trading platforms, trades are executed in standard sizes of 10,000 base currency per one lot, but in other platforms, trades are executed in standard sizes of 100,000 base currency per one lot. Therefore, there is no universal definition of what a “standard-sized” lot is, even though a “standard lot” typically refers to a trade size of 100,000 base currency units in the realm of retail currency trading.

If you want to buy 100,000 EUR/USD, you are actually buying 100,000 Euros. But if your account is denominated in US dollars, then the amount that this position would take up in your account would be however much 100,000 Euros is equivalent to in US dollars at the time. At the same time that you have bought 100,000 Euros, you have sold an amount of US dollars to get this 100,000 Euros. There is usually no maximum trading size, but some some brokers require that you request for a quote over the telephone for trading sizes bigger than 10,000,000 base currency units.

What is a Pip?

A “pip” is the smallest price unit in any currency pair. For example, a movement from 1.5210 to 1.5211 in EUR/USD is one pip, making a pip equivalent to 0.0001. On the other hand, a movement from 105.35 to 105.36 in USD/JPY is also one pip, making a pip equivalent to 0.01.

Relating Pips to Value

For currency pairs where the counter currency is the US dollar like EUR/USD or GBP/USD, one pip equals US$10, for every 100,000 in face value.

So if you have traded one standard lot of GBP/USD, and you have a 20 pip profit, you would get 20 x US$10, which is US$200 profit. However, if you are trading a sub-standard lot of 10,000 in face value, then your profit would be ten times less the amount of that for a standard lot.

If the US dollar is not the counter currency in currency pairs, the value of a pip will be in whatever the counter currency is. In most online trading platforms, you will have access to a pip calculator to calculate for you how much that pip value is when converted to the US dollar if your account is in US dollars.

Rollover:

In the spot forex market, transactions must be settled in two business days from the trade date. This means that if you sell 100,000 US dollars on Monday, you must deliver 100,000 US dollars on Wednesday, unless the position is rolled over. If you hold a spot forex position overnight, your position will be rolled over at 5 p.m. New York time to the next settlement date two business days in the future.

When you hold your positions overnight, you can earn or be charged an extra amount of money, as is true with futures. Depending on the interest rate differential, you may pay or receive interest fees, also known as rollover fees. If you long a currency pair where the base currency has a higher interest rate than the counter currency, then you will receive interest, and vice versa.

Let’s say you buy USD/CHF, and since the interbank interest rates are higher in the US than in Switzerland, you will gain a rollover fee. The amount you receive is determined by the interest rate differential between the two currencies, and fluctuates daily with the movement of prices. On the other hand, if the interest rates are higher in Switzerland, then you may have to pay a rollover fee.

Rollover transactions will be recorded in your account statement, and may be presented in various ways according to different brokers. For example, you may see it in the following simplified format:

30/6/06

LMT

S

1.2389

30/6/06

RCL

S

1.2378

30/6/06

ROP

S

1.23762


In this example, the USD/CHF short position was opened at 1.2389, and during rollover, it was roll-closed (RCL) at 1.2378, and roll-opened (ROP) at 1.23762. Since the US dollar has a higher interest rate than the Franc, going short on USD means you have to pay the difference between the RCL and ROP prices as interest fees.

3-Day Rollover

For positions that are open on Wednesday, and held through 5 p.m. New York time, your rollover fees, whether added or subtracted, tends to be around three times the usual amount. The reason for this is that a 3-day rollover accounts for settlement of trades through the weekend period. The total interest you can pay or receive for the week can only be a maximum of seven days.

What Moves Forex:

Currency market participants, economists and central bankers have been trying to answer the question about what factors drive exchange rates since national currencies come into being. Predicting exchange rates is more art than science; even analysts often have splitting views on the direction of currency prices.

There are basically two primary approaches of analyzing currency markets: fundamental analysis and technical analysis. Fundamental analysis is based on the underlying economic conditions, whereas technical analysis is about using historical price information to forecast future price actions. In recent years, more and more traders are switching to technical analysis, and they are mostly short-term traders. Medium to long-term traders tend to use more of fundamental analysis to predict future currency valuation.

It is not uncommon for the strongest technical signals to be thwarted by reactions to fundamental events. The reverse is also true in that prices may move according to technical patterns even when there are no major news released. Being a pure technical or fundamental trader would mean missing out half of the information, and being kept in the dark.

Fundamental Analysis

Fundamental analysis involves the assessment of macroeconomic indicators, economic growth (capital and trade flows) and geopolitical risks when evaluating the value of a currency relative to another. These forces drive the supply and demand of money.

Major macroeconomic indicators include the Gross Domestic Product (GDP), interest rates, inflation, unemployment, money supply and foreign exchange reserves. Economic growth comprises capital flow and trade flow. Geopolitical issues have an impact on people’s perceptions of a country’s level of stability and of the ability of a country’s government to deal with the political issues at hand. In addition, central banks in various countries may occasionally intervene in the forex market to adjust the value of their currencies, either by increasing domestic currency supply in an attempt to lower the price or by buying their domestic currency in order to raise the price. Sometimes, instead of making physical adjustments, their interventions may come in the form of hints or threats so that the market can pay heed and obey accordingly.

The most dramatic price movements, however, occur when unexpected fundamental events happen. Such events could range from a central bank raising domestic interest rates to the outcome of a political election or even an act of war. Since the market is made up of players, and it is the players’ emotions that determine price actions, the key driver of the currency market is their expectations and perceptions surrounding the event, rather than the event itself.

Technical Analysis

The application of technical analysis to foreign exchange markets is a recent hot development in trading due to the advent of new technologies.

Technical analysis is based on the assumption that all information is already included in the prices. After all, the price at any given time is the sum of the knowledge, fears, hopes and expectations of the people already in the market and those contemplating getting into it. How might those bystanders affect the price? Let’s say if they hold back from buying EUR/USD, they are keeping the price lower than it otherwise would be.

One feature of the market is its discounting mechanism, and it is one of the main reasons for using technical analysis. The market does not actually predict anything, but it reveals what the major market players like hedge funds or trading pros think.

When the forex market anticipates robust economic growth, players become willing to pay more for the country’s currency, and this drives the currency higher. Conversely, when market players expect a slowing economy, they become less willing to bid for the country’s currency if they think that there would be less demand for it as a result. Hence, market participants have already factored in today’s news into the prices, and begun to anticipate tomorrow’s breaking news. In addition, technical analysis works under the assumption that history tends to repeat itself.

Technical traders use charts, support and resistance levels, and numerous patterns and mathematical analyses to identify trading opportunities, based on historical currency data. Technical analysis works well in the forex market because short-term exchange rate fluctuations are primarily determined by human emotions or market perceptions. Perception as reality is very true, and this concept manifests itself strongly in the markets. If you think that a currency is worth x amount against another currency, then it will be what it is worth.

Automated Systems:

Are Mechanical Trading Systems For Sale Any Good?

With an increasing number of ads out there in newspapers and on the Internet, we’ve received emails from readers asking for our opinion on mechanical/automated trading. Should we all rush out to grab one of those mechanical/automated trading systems that are for sale? The lure of such get-rich-quick advertisements certainly appeal to those people who want to make money but are not interested in learning how to.

Our view is that even if those systems are working at the time they are sold, they will soon stop working as more and more people use them. The main reason is that when brokers start noticing many simultaneous orders being placed at the same time, they will create systems to either trade against those orders, or anticipate them. So, profitable automated trading systems will lose their magic once too many people start to use them. Additionally, why would someone who is successfully trading an automated system want to sell it and lose his or her trading income as more and more people use the system?

Besides, even if someone were to use these systems, he or she would have to periodically adapt the systems to changing market conditions. And if that person doesn’t have a full understanding of the systems and the markets, it would be very unlikely to keep these systems profitable over a period of time.

Why is teaching discretionary trading different from selling a mechanical system?

With a mechanical system, trades will automatically be placed in pre-determined market conditions. This means that every trader’s computer that is running the system will place the same trade at the same time, thus affecting the market and the results of the system.

On the other hand, with discretionary trading, a trader ultimately makes his or her own trading decisions as to when to enter and exit a position by taking into consideration a multitude of factors influencing any given currency pair. Thus, the chances of traders who have learnt the same techniques placing exactly the same trade at the same time are very slim.

If you are considering a mechanical trading system, it is better for you to design and test that system yourself rather than trusting blindly in a system for sale which you don’t understand and cannot be sure if the system is profitable or don’t know how to adapt it to changing market conditions.

And in order to reach the stage whereby you can design and test your own systems, you will need a good understanding of technical analysis and the psychology of the forex market.