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Trading Forex

Introduction

This page presents a brief introduction to the world of spot forex trading. It is highly recommended reading for anyone new to forex trading. Experienced traders can choose to skip this page but may however benefit from a refresher of the basic operational mechanics of forex trading.

 

The Basics

Forex trading is the buying (going long) or selling (going short) of one currency with another currency. The primary currencies traded are termed the majors whilst other currencies are termed the minors, or exotics.

The majors are typically considered the US dollar, the Swiss franc, the British pound, the Japanese Yen, the European Union Eurodollar, the Canadian dollar, the Australian dollar, and the New Zealand dollar. The minors are all other currencies offered by forex brokers for trading.

The forex market deems a currency a major based on a combination of factors. These factors include, but are not limited to, an issuing country's absence (in normal times) of exchange-controls, a transparent legal system, a reasonably stable economy, and a tradition of non-whimsical central bank policy objectives and implementation. The foregoing factors tend to guarantee a currency's high liquidity and valuation transparency which are essential ingredients for fair and equitable trading.

Minors are categorized in a somewhat similar fashion with the consequential impact on a particular currency's liquidity and valuation transparency..

 


Conventions

As in all facets of business, participants adhere to a set of well-defined conventions and jargon to ensure the rapid and efficient execution of transactions. The following constitute the core elements of forex trading:-

 

Delivery

In the forex market, one can buy (or sell) a currency with another currency for either spot or forward delivery. Note that the forward price of a currency is always a well-defined mathematical function of its current spot price. Currencies can also be traded on the forex derivative market. In the latter case, the price of a currency's derivative is also a function, albeit a probabilistic one, of its current spot price, impacted by certain other parameters, such as price volatility and transaction time-to-expiration.

 

Currency Pairs

The curreny being bought (or sold) is always quoted, and thus transacted, against another currency. The two currencies thus constitute a traded currency pair or currency product. For example, the the British pound against the US dollar, is identified by the currency pair symbol GBPUSD. A broker quote on this currency pair is simply the number of US dollars it takes to buy (the broker's ask) or sell (the broker's bid) one (1) British pound. Convention further dictates that the reverse symbol USDGBP is NOT a quoted currency pair. Similarly, one will encounter USDJPY but NOT JPYUSD, and so on. This quoting convention is quite arbitrary but one that is adhered to by all market participants for the sake of transactional clarity.

 

The Base currency, and the Secondary currency

The currency being bought (or sold) is termed the base currency, whilst the currency being used to buy (or sell) is termed the secondary currency. For example, in the case of the pound-dollar currency pair, i.e GBPUSD, the GBP is the base currency, whilst the USD is the secondary currency. Some traders prefer to refer to secondary currency as the contra currency since the term secondary is sometimes used to describe any currency that is not a major (i.e a minor, or exotic).

Furthermore, the base currency is always the first symbol in a curreny pair symbol, whilst the secondary currency is always the second symbol in a currency pair symbol. Thus for the dollar-yen currency pair, i.e. USDJPY, the dollar is the base currency whilst the yen is the secondary currency.

 

The Quote, the Bid, the Ask, the Spread, and Pips

Always remember a forex broker's quote on a currency pair is rendered from the point of view of the broker and NOT the client. Thus a quote on the GBPUSD currency pair will be posted as GBPUSD: 1.5034 (the broker's bid) - 1.5036 (the broker's ask). The above quote simply means that the broker will sell one (1) pound for $1.5036 US dollars (the broker's ask) and purchase one (1) pound for $1.5034 US dollars (the broker's bid).

Furthermore, the absolute difference between the bid and the ask is called the spread on the currency pair. In the example above, the spread is thus $0.0002.

For all currency pairs amongst the majors a pip is defined as 0.0001 of the quote price with the EXCEPTION of currency pairs involving the yen, in which case, a pip is defined as 0.01 of the quote price. Thus a quote of GBPUSD: 1.5034 (the broker's bid) - 1.5036 (the broker's ask), means that the GBPUSD currency pair has a 2 pip spread. In the case of a currency pair involving the yen, a quote of USDJPY: 78.40 (the broker's bid) - 78.41 (the broker's ask), means that the USDJPY currency pair has a one (1) pip spread.

 

Trading Lots

The amount of base currency being bought (or sold) is typically a standardized amount. In the world of forex trading, a standard lot is 100,000 units, a mini-lot is 10,000 units, a micro-lot is 1,000, and a flexi-lot is any tradeable amount as permitted by a particular broker. For example, in the case of the GBPUSD, a standard lot is 100,000 pounds, a mini-lot 10,000 pounds, a micro-lot is 1,000 pounds, and a flexi-lot is any arbitrary tradeable amount as may be offered by a particular broker. Please note that NOT all brokers offer micro- or flexi-lots.

 

Trading Accounts

A client wishing to trade forex must first open an account with a forex broker. The broker will then ask the client to make a deposit in a specified currency. This deposit currency determines the account-denomination. Note that most brokers offer dollar-denominated accounts, though there are many who offer a variety of account-denominations. The importance of account-denominations will be addressed later when cross-currency trading is discussed.

A client's deposit with a broker is placed into the client's equity-account. The broker will also open a levered margin-account associated with the client's equity-account. This levered margin-account holds a multiple of the amount that is in the associated equity-account. The multiple is called the margin-account leverage and will typically be 100:1, although some brokers will go as high as 500:1. For example, for a broker offering margin-account leverage of 100:1, a client deposit of $1000 will create an equity-account of $1000 and a associated levered margin-account of $100,000.

It is standard practice for a broker to require that clients maintain a minimum amount in their equity-account (and hence by implication, their levered margin-account). These amounts are respectively referred to as the equity-account minimum and the levered margin-account minimum. This minimum amount requirement is to ensure that in the event of a sudden fall in the value of a client's positions the client's equity does not go negative. If this were allowed to happen, a broker could end up bearing a client's losses until such time that a client can be persuaded (gently or otherwise) to redress the incurred losses.

Now this is the important accounting trick to understand. A client's trades are always conducted from his, or her, levered margin-account. Realized profits (or losses), are credited (or debited) to the client's associated equity-account. Futhermore, all client deposits, or withdrawals, are conducted from the client's equity-account. This is essence of the accounting magic that enables a client to trade up-to $100,000 less levered margin-account minimum with a deposit of only $1000.

Other (albeit minor) factors affecting a client's levered margin-account (and hence associated equity-account) will be discussed later in the section titled "Tips and Tricks".

 

Profits and Losses

Obviously the most alluring aspect of trading the forex markets is the potential that it offers for one to accumulate significantly large profits within a very short period of time with a relatively small equity deposit from the comfort of any location with internet access. It is thus vital to clearly and fully understand how profits (or losses) are computed. This exercise is best illustrated by way of example.

Let's say that a broker posts the following quote GBPUSD: 1.5034 (bid) - 1.5036 (ask). A trader with a dollar-denominated account feels that there is a very high probability that the pound (the base currency) will rise against the dollar (the secondary). The trader therefore executes a buy transaction on the GBPUSD currency pair (as opposed to a sell transaction which will be undertaken if the trader is of the opposite opinion). The trader thus effectively buys pounds at $1.5036 per pound. Sometime later, the broker posts a quote of GBPUSD: 1.5050 (bid) - 1.5052 (ask) and the trader feels that the probability that the pound will rise any further has greatly diminished. The trader then executes a sell on the previously acquired GBPUSD currency pair. The trader thus effectively sells the previously bought pounds at $1.5050 per pound. The trader's profit is therefore $1.5050 (sold at) - 1.5036 (bought at) = $0.0014 (profit) per pound, or 14 pips on the trade.

But exactly what profit did the trader realize? Well, the answer to this question depends on the lot-size transacted. If trader had purchased one standard lot then the profit would be 100,000 x 0.0001 x 14 = $140.00. Or in words, lot size x currency pair pip value x pip gain (or loss). Furthermore, this profit will be automatically deposited into the trader's equity-account and the associated margin-account will be increased by profit x margin account leverage. In the case of a broker offering 100:1 margin-account leverage, the trader's levered margin-account will be increased by 140 x 100 = $14,000.

In the case of a currency pair involving the yen, let's say that a trader executes a mini-lot buy on the USDJPY currency pair when the broker posts a quote of USDJPY: 78.40 (bid) - 78.41 (ask), and subsequently executes a sell when the broker posts a quote of USDJPY: 78.55 (bid) - 78.56 (ask). In this case, the profit is 10,000 x .01 x 14 = Y 1400 (yen).

However, in the case of the USDJPY trade, one further transaction is required since the trader's profit is in a currency (yen) that is different from the trader's dollar-denominated account. The realized yen profit will be immediately converted to dollars at the current USDJPY ask price, i.e. 78.56. The trader's equity-account will therefore be increased by 1400 / 78.56 = $17.82 and the associated levered margin-account will be iincreased by 17.82 x 100 = $1782. Note that this happens in every case when a trader makes a profit (or loss) in a currency that is different from his, or her, account-denominated currency. Or, to put it another way, whenever a trade is conducted on a currency pair where the secondary currency is different from the account-denominated currency.

In cases where a trader makes a loss on the trade, the above steps will apply except that the trader's equity-account will decreased by the calculated loss. Simultaneously, the associated levered margin-account will also be decreased by the calculated loss x margin-account leverage.

It is clear from the above examples that for a winning trade a standard lot is a lot more profitable than trading a mini-lot. Unfortunately, the opposite holds true for losing trades. Novice forex traders are strongly advised to hone their skills using mini-, micro-, or flexi-lots before attempting to trade standard lots.

Unlike the equity markets, where one can miss a once-in-lifetime opportunity to buy a stock when it was selling at a bargain price, the forex markets are continually presenting highly profitable buying (or selling) opportunities. This is one of the main attractions of trading forex, profitable trading opportunities continually abound. The trick is of course to know what and when to buy or sell... the raison d'etre of ssiFX.

 

Other (minor) Transaction Costs

The foregoing was a generalized illustration of how trading profits (or losses) are computed. It is however useful for forex traders to be aware of other, albeit minor, transaction costs.

When a trader executes an order to buy one currency (the base) with another currency (the secondary), the trader is actually assigning the equivalent sum from his, or her, levered margin-account, as collateral in order to borrow the secondary currency to effect the purchase of the base currency. After the transaction, the trader receives the base currency in exchange for the borrowed secondary currency. Thus the trader will thus incur interest on the borrowed secondary currency but will also earn interest on the received base currency. The net of these interest amounts is either deposited to, or withdrawn from, the trader's equity-account when the trade is subsequently closed. As stated earlier, the trader's levered margin-account will also reflect the change in the equity-account x the margin-account leverage.

But exactly how are these interest charges computed? The first thing to understand is that the trading day for forex starts at 5 PM EST and ends at 4:59:59 PM EST except for Fridays close, when trading restarts on Sunday afternoon at 5 PM EST. Secondly, all forex trades are settled two business days after actual trade execution.

Now, for as long as a buy transaction is open on a given currency pair, the prevailing borrowing rate for the specific secondary currency is incurred and the prevailing deposit rate for the specific base currency is earned. The opposite holds true for a sell transaction. Most brokers will apply these charges on a daily basis. However, there are a few brokers who will apply interest charges from the instant a trade is opened to the time the trade is closed thus charging interest on a pro rata daily basis.

Furthermore, the fact that all forex trades are settled two business days after trade execution implies that any trade executed after Wednesday 4:59:59 PM EST will settle no earlier than the following Monday at 9 AM EST.

Note that the above discussion has used the illustration of the base currency being bought with the secondary currency. In the case of the base currency being sold for the secondary currency, then the base currency will incur interest at its prevailing borrowing rate whilst the secondary currency will earn interest at its prevailing deposit rate.

Note further that all of the above trading times were discussed from the point of view of US-based brokerages (hence EST), and without any considerations whatsoever for intervening national banking holidays.

A very significant consequence of the foregoing, is that one can technically borrow and trade capital interest-free. Of course this rather joyous gratis is predicated by trading within the interest-free cut-off periods... i.e utilization of high-frequency trading strategies, which, rather  interestingly, is actually a core aspect of ssiFX.

 

Tips and Tricks

Minimal Spreads

Traders participating in the forex markets on a tactical basis (i.e. not trading on the basis of long-term structural exchange-rate expectations), should always choose brokers with low bid - ask spreads. This is obvious since a trader's transaction cost is always the bid - ask spread. Other transaction costs which may be incurred are the transaction holding-time and and broker policy on holding-time (daily or pro-rata).

Furthermore, a broker may include their commission within the spread, or alternatively charge a stated commission. See the Forex Brokers topic below for more on this important consideration.

 

Account denominations

Cross-currency transactions are trades in which neither the base, nor the secondary currency, are in the account-denomination, e.g. trading the CHFJPY currency pair from a dollar-denominated account. Traders participating in such trades must be aware of the extra cost required to convert profits (or losses) back to the account-denominated currency. Furthermore, this conversion is also required whenever the secondary currency differs from the account-denominated currency, e.g. trading the USDJPY currency pair from a dollar-denominated account as opposed to trading the GBPUSD currency pair, which requires no profit (or loss) conversions.

From the foregoing, a trader should ideally trade currency pairs from accounts denominated in the secondary currency. This may not however always be practical.

In order to mitigate the extra conversion costs described above, an astute trader should consider multiple denominated accounts. Note however that not all brokers offer such accounts.

 

Forex Brokers

Traders should invest adequate time and serious effort in choosing an appropriate forex broker. Avoid non-regulated brokers and always show preference for brokers who are located in jurisdictions where the rule of law is firmly entrenched and enforced. In addition, jurisdictions which enforce strong regulatory mandates without hampering the trading process are highly recommended.

Traders must understand the following broker-classifications, namely, MM (Market-Maker), NDD (Non-Dealing Desk) STP (Straight-Through-Processing), and ECN (Electronically Connected Networks). Tactical traders should avoid MM broker-types as client-orders are manually handled. NDD and STP brokers (which essentially mean the same thing) are always preferable as orders are executed automatically and electronically.

ECN brokers present a highly attractive option for high-frequency trading choice since their spreads tend to be consistently lower (zero at times). Traders must however balance narrower spreads with the commission fees charged by ECN brokers.

 

Entrepreneurial and Institutional Managers

Investors who wish to participate in the forex markets but who possess neither the time nor commitment required for such participation may utilize entrepreneural or institutional hedge-fund managers to trade on their behalf.

UNLESS a hedge-fund manager is a large and well-established institution, an investor must NEVER transfer funds to third-parties for the purposes of trading. Instead, an investor should open a forex account with a broker and simply authorize entrepreneurial, private or institutional hedge-fund managers to trade the forex account which are held in the investor's name. This method will not only protect clients from unscrupulous operators but will also gave clients a great deal of control on the actual management of funds traded on their behalf. In this regard, investors are encouraged to investigate hedge-fund managers utilizing PAMM (Percentage Allocation Management Module) accounts.

 

Conclusion

The above has been a brief attempt to introduce you to the exciting and potentially highly-rewarding world of foreign-exchange trading. It is by no means a comprehensive guide on the subject but merely a first step towards grasping the actual mechanics of trading. Note that, in the interest of clarity, broad simplifications of the process have been made at the cost of actual technical accuracy.

Novices are well-advised to spend lots of time and effort in acquiring a more extensive and deeper knowledge of the subject. Trading forex can literally change your life quite dramatically in a very short time indeed but it comes at the cost of dedication, strong commitment, and lots of patience. You will encounter literature which tells you that over 98% of traders actually lose money. This may indeed be quite true. Greed and a reliance on simplistic analytical tools are the main causes for this sad statistic.. do not become part of it.

Finally, ssiFX Real-Time Systems, Inc. forecasting products are designed to be simple and visually intuitive. The ssiFX forecasting system can be effectively used by anyone with a basic understanding of forex trading within a few hours. If you feel that you have an interest in forex trading, the first step is to register as a demo client with a forex, preferably ECN, broker (there are multitudes of them on the internet). Learn and practice the mechanics of trading, i.e. how to execute a buy and sell transaction, and how to compute profits and losses. Only when you feel that you are quite comfortable with the basics of forex trading, register for a (limited-time) demo trial with ssiFX Real-Time Systems, Inc. and challenge your newly-acquired skills.