Forex
The main principles of trading
Introduction to Trading Forex
Foreign Exchange
This short introduction explains the basics of trading Forex online, a brief explanation of the markets and the major
benefits of trading Forex online. There are also two scenarios describing the implications of
trading in a bear as well as bull market to better acquaint you with some
of the risks and opportunities of the largest and most liquid market in the
world.
As an additional aid for those who are new to Forex, there is also a glossary at the bottom of
this text which explains some of the terms used in connection with currency trading.
Overview
Foreign exchange,
forex or just
FX are all terms used to
describe the trading of the world's many currencies. The
forex market is the largest market in
the world, with trades amounting to more than USD 1.5 trillion every day. This is more than one hundred times the daily
trading on the
NYSE (New York Stock Exchange). Most forex trading is
speculative,
with only a few percent of market activity representing governments' and companies' fundamental currency conversion needs.
Unlike trading on the stock market, the forex market is not conducted by a central exchange, but on the
interbank market, which is thought of as an OTC (over the counter) market. Trading takes
place directly between the two counterparts necessary to make a trade, whether over the telephone or on electronic
networks all over the world. The main centres for trading are Sydney, Tokyo, London, Frankfurt and New York. This
worldwide distribution of trading centres means that the forex market is a 24-hour market.
Trading Forex
A currency trade is the simultaneous buying of one currency and selling of another one. The currency combination
used in the trade is called a cross (for example, the Euro/US Dollar, or the GB Pound/Japanese Yen.).
The most commonly traded currencies are the so-called majors EURUSD , USDJPY , USDCHF and GBPUSD .
The most important forex market is the spot market as it has the largest volume. The market is called the
spot market because trades are settled immediately, or on the spot.
In practice this means two banking days.
Forward Outrights
For forward outrights, settlement on the value date selected in the trade means that even though the trade itself is
carried out immediately, there is a small interest rate calculation left.
The interest rate differential doesn't usually affect trade considerations unless you plan on holding a position
with a large differential for a long period of time. The interest rate differential varies according to the cross
you are trading. On the USDCHF , for example, the interest rate differential is quite small, whereas the differential
on NOKJPY is large.
This is because if you trade e.g. NOKJPY, you get almost 7% (annual) interest in Norway and close to 0% in Japan.
So, if you borrow money in Japan, to finance the trade and buying NOK, you have a positive interest rate differential.
This differential has to be calculated and added to your account. You can have both a positive and a negative interest
rate differential, so it may work for or against you when you make a trade.
Trading on Margin
Trading on
margin means that you can buy and sell assets that represent more value than the capital
in your account. Forex trading is usually conducted with relatively small margin deposits. This is useful since it
permits investors to exploit currency
exchange rate fluctuations which tend to be very small.
A margin of 1.0% means you can trade up to USD 1,000,000 even though you only have $10,000 in your account.
A margin of 1% corresponds to a 100:1
leverage (or 'gearing'). (Because USD 10,000 is 1% of
USD 1,000,000.) Using this much leverage enables you to make profits very quickly, but there is also a greater risk
of incurring large losses and even being completely wiped out. Therefore, it is inadvisable to maximise your leveraging
as the risks can be very high. For more information on the trading conditions of Saxo Bank, go to the Account Summary
on your SaxoTrader and open the section entitled "Trading Conditions" found in the top right-hand corner of the
Account Summary.
Why trade Forex?
24 hour trading
One of the major advantages of trading forex is the opportunity to trade 24 hours a day from Sunday evening (20:00 GMT)
to Friday evening (22:00 GMT). This gives you a unique opportunity to react instantly to breaking news that is
affecting the markets.
Superior liquidity
The forex market is so liquid that there are always buyers and sellers to trade with. The liquidity
of this market, especially that of the major currencies, helps ensure price stability and narrow
spreads. The liquidity comes mainly from banks that provide liquidity to
investors, companies, institutions and other currency market players.
No commissions
The fact that forex is often traded without commissions makes it very attractive as an investment opportunity for
investors who want to deal on a frequent basis.
Trading the majors is also cheaper than trading other cross because of the high level of
liquidity. For more information on the trading conditions of Saxo Bank, go to the Account Summary on your SaxoTrader
and open the section entitled "Trading Conditions" found in the top right-hand corner of the Account Summary.
100:1 Leverage
Leverage (gearing) enables you to hold a position worth up to 100 times more than your margindeposit.
For example, a USD 10,000 deposit can command positions of up to USD 1,000,000 through leverage. You can leverage
the first USD 25,000 of your investment up to 100 times and additional collateral up to 50
times.
Profit potential in falling markets
Since the market is constantly moving, there are always trading opportunities, whether a currency is strengthening
or weakening in relation to another currency. When you trade currencies, they literally work against each other.
If the EURUSD declines, for example, it is because the U.S. dollar gets stronger against the
Euro and vice versa. So, if you think the EURUSD will decline (that is, that the Euro will weaken versus the dollar),
you would sell EUR now and then later you buy Euro back at a lower price and take your profits. The opposite trading
scenario would occur if the EURUSD appreciates.
Important Forex Trading Terms
Spread
The spread is the difference between the price that you can sell currency at
( Bid) and the price you can buy currency at ( Ask). The spread on majors
is usually 3 pips under normal market conditions. For more information on the trading conditions at Saxo Bank,
go to the Account Summary on your Client Station and open the section entitled "Trading Conditions" found in the
top right-hand corner of the Account Summary.
Pips
A pip is the smallest unit by which a cross price quote changes. When trading forex you will often hear that there
is a 3-pip spread when you trade the majors. This spread is revealed when you compare the bid
and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of
0.9878. The difference is USD 0.0003, which is equal to 3 pips.
On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with
four decimals, so all you have to do is cancel out the four zeros on the amount you trade and you will have the va
value of one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip
is equal to 1000 yen, because USDJPY is quoted with only two decimals.
Trading Scenario Trading Rising Prices
If you believe that the Euro will strengthen against the dollar you'll want to buy Euro now and sell it
back later at a higher price.
You buy Euro |
|
We quote EURUSD at Bid 0.9875 and Ask 0.9878,
which means that you can sell 1 Euro for 0.9875 USD or buy 1 Euro for 0.9878 USD .
In this example you buy Euro 100,000, at the quote price of 0.9878 (ask price) per Euro.
|
The market moves in your favor |
|
Later the market turns in favour of the Euro and the EURUSD is now quoted
at Bid 0.9894 and Ask 0.9896. |
Now you sell your Euro and get the profit |
|
You sell Euro at a Bid price of 0.9894. |
The profit is calculated as follows |
|
Sell price-buy price x size of trade
(0.9894 minus 0.9878) multiplied by 100.000 = USD 140 Profit
(Note that the profit or loss is always expressed in the secondary currency) |
Trading Scenario Trading Falling Prices
If, on the other hand, you believe that the Euro will weaken against the dollar, you'll want to sell EURUSD .
You sell Euro |
|
We quote EURUSD at a Bid price of 0.9875 and
Ask price of 0.9880 and you decide to sell Euro 100,000 at a
Bid price of 0.9875. |
The market moves in your favour |
|
The Euro weakens against the dollar and the EURUSD is now quoted at bid 0.9744
and ask 0.9749. |
Now you buy back your Euro |
|
You buy EUR at an ask price of 0.9749. |
Your Profit/loss is then |
|
Sell price-buy price x size of trade
(0.9875 minus 0.9749) multiplied by 100.000 = USD 1260 Profit |
Remember that trading EUR 100,000 as we have done in our examples, does not mean that you have to put up Euro 100,000
yourself. On a 2% margin means that you have to deposit 2.0% of Euro 100,000, which is Euro 2,000 on margin as a guarantee for
the future performance of your position.
Further Reading
To see how you can trade the forex market and benefit from our toolbox of information and live quotes, please
proceed to the Forex Quick Start found under the Trading menu of SaxoTrader.
Glossary
Appreciation |
|
An increase in the value of a currency. |
Ask |
|
The price requested by the trader. This usually
indicates the lowest price a seller will accept. |
Base currency |
|
The currency that the investor buys or sells (i.e. EUR in EURUSD ). |
Bear |
|
Someone who believes prices are heading down. A bear market is one in which there is a sustained fall in
prices and which does not look like it will recover quickly. |
Bid |
|
The price offered by the trader. This usually indicates the highest price a purchaser will pay.
|
Bid/Ask |
|
The Bid rate is the rate at which you can sell. The Ask (or offer) rate is the rate at which you can buy. |
Bull |
|
Someone who is optimistic about the market. A bull market is characterised by enthusiastic and
sustained buying. |
cross |
|
When trading with currencies, the investor buys one currency with another. These two currencies
form the cross: for example, EURUSD . |
Cross rate |
|
An exchange rate that is calculated from two other exchange rates. |
Depreciation/decline |
|
A fall in the value of a currency. |
Exchange rate |
|
What one currency is worth in terms of another, for example the Austrialian dollar might be worth 58 US cents
or 70 yen.
Currencies traded freely on foreign-exchange markets have a spot rate (applying to
trades settled 'spot', ie, two working days hence) and a forward rate. Countries can determine
their exchange rates in a variety of ways.
1. A floating exchange rate system where the currency finds its own level in the market.
2. A crawling or flexible peg system which is a combination of an officially fixed rate and
frequent small adjustments which in theory work against a build-up of speculation about
a revaluation or devaluation.
3. A fixed exchange-rate system where the value of the currency
is set by the government and/or the central bank. |
EURUSD |
|
Means that you trade EUR against dollars. If you buy Euro you pay in dollars and if you sell
Euro you receive dollars. |
FX, Forex, Foreign Exchange |
|
All names for the transaction of one currency for another, e.g. you buy £100.00 with
USD 150.25 or sell USD 150.25 for £100.00. |
Interbank |
|
Short-term (often overnight) borrowing and lending between banks, as distinct from banks'
business with their corporate clients or other financial institutions. |
Interest rate differential |
|
The yield spread between two otherwise comparable debt instruments denominated in different currencies. |
Leverage (gearing) |
|
In this case leverage means that the investor only funds part of the amount traded. |
Long |
|
To buy. |
Long position |
|
A position that increases its value if market prices increase. |
Liquid (-ity) |
|
The capacity to be converted easily and with minimum loss into cash. A liquid market is one in which there is enough activity to satisfy
both buyers and sellers. Ultra-short-dated treasury notes are an example of a liquid investment.
|
Margin |
|
Thedeposit required when entering into a position as well as to hold an open position. Your margin
status can be monitored in the Account Summary. |
NYSE |
|
The New York Stock Exchange. |
Open position |
|
A position in a currency that has not yet been offset. For example, if you have bought 100,000
USDJPY , you have an open position in USDJPY until you offset it by selling 100,000 USDJPY , thus
"closing" the position.
|
Over the counter |
|
When trading takes place directly between two parties, rather than on an exchange.
Over the counter trades can be customised whereas exchange-traded products are often standardised.
|
Pips |
|
A pip is the smallest unit by which a Forex cross price quote changes. So if EURUSD bid is now
quoted at 0.9767 and it moves up 2 pips, it will be quoted at 0.9769. |
Position |
|
Traders talk of 'taking a position' which simply means buying or selling currency cross. 'Position'
can also refer to a trader's cash/securities/currencies balance, whether he or she is short of cash, has
money to lend, is overbought or oversold in a currency, etc. |
Risk |
|
Trying to control outcomes to a known or predictable range of gains or losses. Risk management
involves several steps which begin with a sound understanding of one's business and the exposures
or risks that have to be covered to protect the value of that business. Then an assessment should
be made of the types of variables that can affect the business and how best to protect against
unwelcome outcomes. Consideration must also be given to the preferred risk profile - whether
one is risk- averse or fairly aggressive in approach. This also involves deciding which instruments
to use to manage risk, and whether a natural hedge exists that can be used. Once undertaken, a
risk-management strategy should be continually assessed for effectiveness and cost. |
Secondary currency (variable currency or counter currency) |
|
The currency that the investor trades the base currency against (i.e. USD in EURUSD ). |
Short position |
|
A position that benefits from a decline in market prices. |
Short |
|
To sell. |
Speculative |
|
Buying and selling in the hope of making a profit, rather than doing so for some fundamental
business-related need. |
Spot |
|
A Spot rate is the current market price of an asset. |
Spot market |
|
The part of the market calling for spot settlement of transactions. The precise meaning of
'spot' will depend on local custom for a commodity, security or currency. In the UK, US and
Australian foreign-exchange markets, 'spot' means delivery two working days hence.
|
Spread |
|
The difference between the bid and the ask rate. |
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