Basic Concepts of Forex
Basic Concepts of Forex
October 27, 2007
How is foreign exchange traded?
Currencies are quoted in pairs, such as EUR/USD or USD/JPY. The first listed currency is known as the base currency, while the second currency is called the counter or quote currency. The base currency is the “basis�for the Ask or the Bid. For example, if you Ask EUR/USD you have bought Euros (and simultaneously sold dollars). You would do so in expectation that the Euro will appreciate (go up) relative to the US dollar. FX is traded in lots, which represent 100,000 units of the base currency. If the EUR/USD is quoted at 1.2253, that means that one Euro is currently worth just over $1.22. If the market moves from 1.2253 up to 1.2254 that represents a move of one pip. A pip is the smallest increment a currency pair can move and in the case of the EUR/USD currency pair a pip is worth $10 in a 100K account and is $1 in a mini account.
An FX Trade Example
If you think that the Euro will rise relative to the U.S. Dollar you would Ask one lot of the EUR/USD currency pair.
The EUR/USD is trading at 1.2553 when you Ask it.
The EUR/USD is trading at 1.2674 when you Bid it.
You bought at 1.2553 and sold at 1.2674 for a profit of .0121 or 121 pips.
Each pip is worth $10 in the 100K account.
121 pips x $10 = $1,210 profit
In FX, you also have the opportunity to short (Bid first) a currency pair if you think it will fall in price.
If you think that the Euro will fall relative to the U.S. Dollar you would Bid one lot of the EUR/USD currency pair.
The EUR/USD is trading at 1.2659 when you Bid it.
The EUR/USD is trading at 1.2523 when you Ask it.
You bought at 1.2523 and sold at 1.2659 for a profit of .0136 or 136 pips.
Each pip is worth $10 in a 100K account.
136 pips x $10 = $1,360 profit
While these are profitable examples, remember that ending up on the wrong side of a trade can cost you a lot of money.
Currency Pairs
What is the significance of currency pairs?
A currency pair represents the exchange rate between the two currencies. For example, the rate at which the EUR/USD is trading that represents the number of US Dollars one Euro can purchase. The first currency is called the base currency and the second currency is called the counter currency.
An example of how currency pairs trade is if a trader believes the Bank of Japan will intervene to cause a decrease in the Yen against the US Dollar, then the trader would Ask USD/JPY (Ask the US Dollar/Bid the Yen). However, if the trader believes that Japanese investors are losing faith in the United States�economy and are pulling money out of the US into Japan, then the trader would Bid USD/JPY (Bid the US Dollar/Ask the Yen).
This is an example of how currency pairs are listed on trading stations.
The currency pairs are listed on the left side of the column. The Bid price is the level at which a trader can Bid the currency pair and the Ask price is the level at which a trader can Ask the currency pair.
The Concept of Leverage �
What is leverage?
Leverage allows traders to borrow money and use that money to invest in the foreign exchange market. Because of leverage, clients without a huge amount of capital are able to make large investments, whereas in other markets such as the equities market, clients would have to pay 50% of the full amount for each share of stock they were investing in. Most market makers allow positions to be leveraged up to 100:1. This means that if a trader wanted to Ask a “lot�worth $100,000, with 100:1 leverage the trader only has to put up $1,000.
Leverage is about risk. Increasing your leverage increases both your opportunity to take bigger profits AND rack up bigger losses.
It’s easy to see in this graph that the amount of margin required in taking positions in the currencies market is much less than in the equities and futures markets.
What is margin?
Margin is a performance bond, or good faith deposit, to ensure against trading losses. The margin requirement allows traders to hold a position much larger than the account value.In the event that funds in the account fall below margin requirements, your broker will close some or all open positions. This prevents clients�accounts from falling into a negative balance, even in a highly volatile, fast moving market.
For example, let’s say you have an account with $10,000. That means you have $10,000 of usable margin. If you use $7,000 to Ask 7 lots of USD/JPY, you now have $3,000 of usable margin left, meaning that you are allowed to lose $3,000 before you are under the margin requirement. The account equity remains at $10,000 until you begin to make or lose money on the position. Now, if the USD/JPY decreases to the point that you end up losing the $3,000 which is left in your account, then the broker will close all of your positions to ensure that you do not lose more than you have in your account.
How are leverage and margin related?
Leverage and margin are related in the way mentioned above �the amount of leverage a market maker gives to a client defines the amount of margin that the client will have to commit in order to take a position in the market. For example, when leverage is 100:1, the �/P>
1�/P>
in the leverage ratio signifies the amount of capital the customer has invested of his own money, which is also known as the margin.
Trading Costs
How much does it cost for a trader to make a trade?
Traders do not take positions on a currency pair at the exact rate at which the currencies are trading. Instead, there are two rates for the currency pair: the bid rate and the ask rate.
• The bid rate is the price at which traders can Bid the pair.
• The ask rate is the price at which traders can Ask the pair.
This is an example of a currency pair. The ask (Ask) rate is higher than the bid (Bid) rate and the spread is 3 pips, meaning that if a trader Asks this pair, then the Bid rate of this pair will have to go up 3 pips in order for the trader to break even.
The ask rate will always be higher than the bid rate. The difference between the bid rate and the ask rate is the spread. The spread is an automatic cost that the trader incurs when making the trade. Because of this spread, traders will take a position they started with a small loss and will need to gain some profit in order to break even.
For example, if a trader Asks into a position at the ask rate, and then immediately closes the position at the bid rate, the trader will incur a cost equal to the spread.
These spreads are seen in every kind of market. However, because of the broker-based system in the equities and futures market, it can sometimes be difficult to identify where and how much the spread cost is.
Fundamental Analysis
What influences prices in the forex market?
Prices in the currencies market are affected by macroeconomic factors, such as inflation, unemployment, and industrial production. Information on events such as these is easy to find and are based on their analysis of economic data, which traders take positions on the market to make profit.
There are three main macroeconomic factors a trader should focus on when analyzing foreign exchange rates:
Interest Rates: Each currency has an overnight lending rate attached to which is determined by that country’s central bank. Lower interest rates usually lead to depreciation in the value of the country’s currency
This is largely due to traders who execute carry-trades. A carry-trade is a trade where a currency with a low interest rate is sold and a currency with a high interest is bought. This is based on the idea that currencies with higher interest rates will generally rise in value, and will rollover and allow trades to earn interest on a daily basis.
Employment: The unemployment rate is a key indicator of its economic strength. If a country has a high unemployment rate, it means its economy is not strong enough to provide people with jobs, and thus, leads to a decline in the currency value.
Geopolitical Events: Key international political events that affect not only the foreign exchange market, but all other markets as well.
Fundamental Analysis Techniques
How does fundamental analysis explain long term trends?
Fundamental analysis is very useful for determining long-term trends within a currency pair. By focusing on long term economic factors that affect countries, fundamental analysis predicts long term trends.
Currency Pair Relations
EUR/USD
When the dollar weakens the EUR/USD will rise and if the USD recovers then a strong foreign demand will send EUR/USD lower If you think the U.S. economy will become weaker and hurt the US Dollar, you can ASK, which means that you are Asking Euros and expecting them to go up against the US Dollar.If you think that there will be increased foreign demand for US financial instruments such as equities and treasuries, and that benefit the US Dollar, click on BID, which means that you are Asking U.S. Dollars, expecting them to climb in value against the Euro
USD/JPY
Japanese government intervention to weaken their currency sends USD/JPY higher and gains in Nikkei and demand for Japanese assets drive USD/JPY down. For example, you think that the Japanese government will continue to weaken the yen in order to help its export industry, you would click on ASK, expecting the U.S. dollar to increase in value against the yen. If you think that Japanese investors are pulling money out of U.S. financial markets and repatriating funds back into the Japanese asset markets, such as the Nikkei, you would click on BID. This means that you expect the Yen to strengthen against the U.S. Dollar as Japanese investors Bid their assets and convert their Dollars back into Yen.
GBP/USD
High Yield and attractive growth in the UK drives GBP/USD higher speculation about UK adopting the euro will send the GBP/USD lower. For example, you think the British economy will continue to benefit from its high yield and attractive growth, thus buoying the Pound, you would click ASK, which means that you expect the British Pound to strengthen against the U.S. Dollar. If you believe the British are about to commit themselves to adopting the Euro, you would click BID, expecting the Pound to weaken against the Dollar as the British devalue their currency in anticipation of merging with the euro.
USD/CHF
Global stability and global recovery will send USD/CHF higher USD/CHF rallies on geopolitical instability. For example, you think that the market is headed towards a period of global stability and economic recovery, meaning that investors no longer need to park their money in the safe haven currency such as the Swiss Franc, you would click ASK, expecting the U.S. Dollar to strengthen against the Swiss Franc. If you believe that due to instability in the Middle East and in U.S. financial markets, the dollar will continue to weaken, you would click BID, expecting the Swiss Franc to strengthen against the dollar.
EUR/CHF
Swiss government uses verbal intervention to weaken the Franc, sending EUR/CHF higher. For example if inflation took off in Germany and France it could drive EUR/CHF lower.
Thus for example if you think the Swiss government wishes to devalue the currency to help exports in Europe, you would click ASK, expecting the Euro to increase in value against the Swiss Franc. If inflation started taking off in Germany and France, you would click BID expecting the Swiss Franc to increase in value against a devalued Euro.
AUD/USD
Rising commodity prices sends AUD/USD higher Droughts hurt Australian economy and AUD/USD. For example, you think that commodity prices are going to rise dramatically, thus benefiting the Australian Dollar, you would click ASK, expecting the Aussie to strengthen against the U.S. Dollar due to Australia’s status as one of the world’s leading commodity exporters. If you believe that Australia will face another drought, hurting the domestic economy, you would click BID, expecting the U.S. Dollar to strengthen against the Australian Dollar.
USD/CAD
Canadian economic underperformance against US sends USD/CAD higher
Higher interest rates and rebounding labor market in Canada will help to drive USD/CAD lower
If, for example, you think that the
U.S.
economy is going to rebound while the Canadian economy goes into recession, you would click ASK, expecting the U.S. Dollar to strengthen against the Canadian Dollar. If you believe that the higher yields and rebounding labor market in
Canada
warrants a higher valuation for the Canadian Dollar against the U.S. dollar, you would click BID, expecting the Canadian Dollar to decline against the U.S. dollar.
NZD/USD
Bad weather in US increases demand for foreign wheat sending NZD/USD higher
New Zealand Interest rates expected to decrease sending NZD/USD lower
If, for example, you think that Hurricane damage in the US will lead to an increase for wheat imports from foreign nations such as New Zealand, you would click ASK, expecting the New Zealand Dollar to strengthen in value against the U.S. dollar. If you felt that interest rates in New Zealand would fall in the future while interest rates in the US will continue to rise, you would click BID expecting the New Zealand to drop in value against the U.S. Dollar.
Technical Analysis
What is so great about technical analysis?
Once a trader masters technical analysis, it is easy to apply it to any currency or time frame, and thus allowing a relatively short time to figure out where trends are going. Because of the short time, technicians can follow numerous currencies at the same time, whereas fundamentalists usually focus on one or two pairs of currencies, because there is so much information in the market to analyze.
Traders using fundamental analysis can run into trouble because there are so many different ways to analyze market information. This causes controversy and can lead to misdirection, misunderstanding and ultimately, loss of money. On the other hand, technical analysis can be much more straightforward. Many traders even consider it to be a self-fulfilling prophecy, meaning that it works well because so many traders use it. This is an important aspect of technical analysis because if many traders are basing their decisions on technical indicators, then the indicators must be watched since they reflect the sentiment of the market and the majority of the traders.
Why is the foreign exchange market the best market to use technical analysis?
The foundation behind using technical analysis is to find trends when they first develop, which allows the trader to ride the trend until it ends. The foreign exchange market is typically composed of trends and is, therefore, a place where technical analysis can be effective. Traders are able to speculate on both up and down trends in the foreign exchange market because it is possible to Ask a currency and Bid against another currency. This aspect of currency trading works well with technical analysis, because technical analysis helps determine where the trends are and which way they are going, thus giving the trader a chance of profiting from the market, regardless of its direction.
In comparison to the equities and futures markets, technical analysis is much more common and popular within the foreign exchange markets, which causes the traders to pay attention. The market partly moves because of all the technical analysis performed. For example, according to technical analysis, if a currency pair decrease, then the majority of traders will Bid the pair, causing it to drop further.
Support and Resistance
At the core of all technical analysis theory are two very simple concepts: support and resistance. Support can be defined as a “floor�through which the currency pair has trouble falling below. There is no scientific formula for calculating support; it is something that is typically “eyeballed�by traders, and hence involves somewhat of a subjective element.
Resistance, on the other hand, is simply the opposite: it is the upper boundary through which a currency pair has trouble breaking. Similar to support, resistance levels are somewhat subjective. Generally, if the market reaches a certain number of times and cannot sustain a break above that level; it can be identified as resistance.
The reason why price has trouble breaking these levels is the presence of actual orders around these levels. A support level is simply a price area where Ask orders tend to be, and so it takes more than normal Biding pressure to break that level. Similarly, a resistance level is a price area where Bid orders tend to be, and so it takes more than normal Asking pressure to break that level.
Support and Resistance in a Range- Trading Markets
One simple way to use support and resistance in trading is to simply trade the range: in other words, traders can simply Ask at support level, and Bid at resistance level. A key advantage of this is that the FX market is range-bound a majority of the time, making it an attractive strategy for many market conditions.
The two disadvantages of range - trading:
Trading in a range generally does not result in substantial gains on a per-trade basis.
When the market breaks out of the range, generally it will make big moves. As a result, traders trading with range strategies can suffer big losses when the market breaks out of the range.
The chart below illustrates the concept of range-bound trading.
Support and Resistance in Momentum Markets
Another way to use support and resistance is to trade outside of the range; in other words, to anticipate a breakout. This involves placing orders to Ask above resistance and to Bid below support. The rationale is that the market will gain momentum once it breaks out of the range, and thus by placing orders just below or above of support or resistance, traders may be able to profit if the market continues to move out of the range and they are on the right side of the market. Momentum trading is a bit counter-intuitive, as it involves Asking at a higher price and Biding at a lower price.
Below is a chart that illustrates the concept of momentum trading.
Oscillators
Oscillators are a class of mechanical trading tools that offer indications of when a currency pair is overbought or oversold. A popular oscillator is the Relative Strength Index.
Relative Strength Index
The relative strength index (RSI) is a momentum indicator that measures a currency pair’s strength relative to its won recent past performance. As the indicator is front-weighted (more importance is given to the most recent data), it typically provides a better velocity reading than other oscillators. RSI is less affected by sharp movements, and filters out a lot of “noise�in the Forex market. Many traders also use this indicator as a substitute for volume confirmation, since the over-the-counter structure of the FX market does not allow for real-time volume reporting.
RSI’s levels are between 0 and 100. Most traders use 30 as an oversold condition and 70 and as overbought condition, although some traders may use 20 and 80. When choosing the settings for RSI, traders should typically use the default time period of 14, since that is what the market as whole tends to look at.
In general RSI is used in five different ways:
Top and Bottoms - Overbought and Oversold conditions are usually signaled at 30 and 70.
Divergences - When a pair makes new highs (lows) but RSI does not, this usually indicates that a reversal in price is coming.
Support and Resistance - RSI may show levels of support and resistance, sometimes more clearly than the price chart itself.
Chart Formations - Patterns such as double tops and head and shoulder may be more visible on RSI rather than on the price charts.
Failure Swings - When RSI breaks out (surpasses previous high or low), this may indicate that a breakout in price is coming.
RSI was useful in detecting this USD/JPY short after a crossover of the 70 “overbought�level materialized on the daily. Following the clear Bid signals, the pair moved down 450 pips over the next 30 days.
Risk Management
There are three basic questions that every trader should answer BEFORE entering a trade.
How much do I believe the market will move and where do I want to take my profit?
Limit Orders allow traders to exit the market at profit targets. If you are short (sold) the system will only allow you to place a Limit Order below the current market price because this is the profit zone. Similarly, if you are long (bought) the system will only allow you to place a limit order above the current market price. Limit orders help create a disciplined trading methodology and enables traders to walk away from the computer without constantly monitoring the market.
How much am I willing to lose before I exit the position?
A stop/Loss order allows traders to set an exit point for a losing trade. If you are short a currency pair the stop loss order should be placed above the current market price. If you are long the currency pair the stop loss order should be placed below the current market price. Stop/Loss orders help traders control risk by capping losses. Stop/Loss orders are counter-intuitive because you do not want them to be hit; however, you will be happy that you placed them! When logic dictates, you can control greed.
Where should I place my stop and limit orders?
As a general rule of thumb traders should set Stop Orders closer to the opening price than limit orders. If this rule is followed, a trader needs to be right less than 50% of the time to be profitable. For example, a trader that uses a 30 pip Stop/Loss and 100 pip limit orders needs only to be right 1/3 of the time to make a profit. Where the trader places the stop and limit it will depend on how risk-adverse he/she is. Stop/Loss orders should not be so tight that normal market volatility knocks the position out. Similarly, Limit Orders should reflect realistic expectation of gains given the markets trading activity and the length of time one wants to hold the position.
Psychology of the Trader
What should the psychology of the trader be?
Before placing trades, traders must sufficiently analyze the position they are about to take. However, many do not thoroughly plan out their actions, and instead make trades based on guesses and hunches. This psychological viewpoint can result in traders losing a
lot of money very fast. How can this be avoided? Through careful planning and analyses, including where to place stop and limit orders, a trader can keep losses to a minimum while allowing profits to run.
Make sure to have a plan that utilizes stop and limit levels before making the trade in order to minimize losses and lock in on profits.
One huge psychological error that many traders make is going against their original plan and either closing positions to take a profit before they reach the profit target or not closing a losing position in the hopes that the market will come back in their favor. Another psychological error traders make is to believe that every trade should be profitable. If there is an instance where a stop is hit and then the market goes back in favor of the position the trader had held, this belief can cause the trader to remove stops from their trades.
What is often forgotten is that stops are there to keep them from losing more money than they would like, not to be some sort of roadblock against profit. It is okay to hit stops and lose the pre-determined amount of money because when a trader is lets profitable trades run, the loss will be made up for and more. Do not try to improvise. Stick with the original plan and precautions made before the trade.
Another psychological error traders make is becoming too committed to a trade and unwilling to let it go. A trader must keep his original analysis in mind when seeing the result of a trade, and be objective about what is happening to his position and what he should do about it. However, many traders attempt to analyze the position differently from the original analysis so that the analysis will favor their original position. They intentionally distort their analysis for one of two reasons: they do not want to close the position with a loss or they are hoping that the position will become more profitable than it already is.
This psychological viewpoint causes many traders to lose the profit that they had made or lose more than they originally would have lost. Just because leverage is provided does not mean it is okay to trade large portions of the account at a time or too frequently. A prevalent mistake made by many traders is overtrading, meaning that they trade much larger amounts of their account than is reasonable or trade too frequently. Although leverage allows traders to trade one lot of currency with only $1,000 as a margin deposit, it does not mean that traders should trade their entire available margin in one or two trades.
The psychological mistake they are making is that they are thinking of their trade as a $1,000 investment, when in actuality it is a $100,000 investment. Although most traders perform adequate analysis of currencies before placing trades, they sometimes use too much of their margin and are later forced to exit the position at the wrong time. A general rule that traders try to follow in order to keep themselves from getting over-leveraged is never using more than 20% of the account at any given time.