Introduction to Forex Trading
The 1971 abandonment of the Bretton Woods Accord and the
subsequent unwinding of the system of fixed exchange rates gave rise to the
foreign exchange market as we know it today.
Forex refers to the foreign
exchange market, where brokerage firms and banks are connected over an
electronic network that allows them to convert the currencies of countries
around the globe.
The forex market is the largest and most liquid
financial market in the world. The daily dollar volume of currencies traded in
the currency market exceeds $1.9 trillion, many times larger than the combined
volume of all U.S. equities and futures markets.
While forex trading
used to be executed exclusively between government central banks and commercial
and investment banks, trading forex has become increasingly accessible to
private investors thanks to the PC and internet.
The most commonly
traded currencies are the US Dollar, Japanese Yen, Euro, British Pound, Swiss
Franc, Canadian Dollar and Australian Dollar. The FX market runs 24-hour hours a
day, 5 days a week with continuous access to global dealers. Trading is not
centralized on a physical location or an exchange, as with the stock and futures
markets.
Foreign Exchange is the simultaneous buying of one currency and
selling of another. Currencies are traded in pairs, for example Euro/US Dollar
(EUR/USD) or US Dollar/Japanese Yen (USD/JPY).
For example, you would
execute a trade when you expect the currency you are buying to increase relative
to the one you are selling. If the currency you are buying increases in value,
you must sell the other currency to close the position and take a profit. The
first currency in the pair is called the base currency and the second is called
the counter or quote currency. Usually the US currency is the base currency and
quotes are given in $1 USD per counter currency, e.g. USD/JPY. The exceptions
are the British Pound, the Euro and the Australian Dollar.
Understanding
forex quotes: 1 unit of the base curreny = the exchange rate in the quote
currency. I.e. if EUR/USD is trading at 1.2762, 1 Euro will buy you 1.2762
Dollars.
Understanding contract size in forex trading: The contract size
is normally a lot of 100,000. This means per standard contract you are
controling 100,000 units of each pair, so if you are buying eur/usd you would be
buying 100,000 euro's and selling 100,000 dollars simultaneously. For this
contract size, each pip (the smallest price increment) is worth $10. Many firms
offer mini accounts now where you can trade units of 10,000, where the pip value
is $1.
Trading the Forex market allows very low margin requirements
relative to other markets.
Forex Basic Dictionary
The following is an introduction to some basic terms, definitions and concepts used in forex trading. It is designed to be read in chronological order, starting with the most simplest terms and moving through to some more advanced terms used in the forex market, or you can click on any individual term if you want an explanation of a specific term.
Introduction
The simultaneous transaction of one currency for another.
The Foreign exchange market is a large, growing and liquid financial market that operates 24 hours a day. It is not a market in the traditional sense because there is no central trading location or "exchange". Most of the trading is conducted by telephone or through electronic trading networks. The primary market for currencies is the "interbank market" where banks, insurance companies, large corporations and other large financial institutions manage the risks associated with fluctuations in currency rates.
The market for buying and selling currencies at the current market rate.
A spot transaction is generally due for settlement within two business days (the value date). The cost of rolling over a transaction is based on the interest rate differential between the two currencies in a transaction. If you are long (bought) the currency with a higher rate of interest you will earn interest. If you are short (sold) the currency with a higher rate of interest you will pay interest. Most brokers will automatically roll over your open positions allowing you to hold your position indefinitely.
The value of one currency expressed in terms of another. For example, if EUR/USD is 1.3200, 1 Euro is worth US$1.3200.
The two currencies that make up an exchange rate. When one is bought, the other is sold, and vice versa.
The first currency in the pair. Also the currency your account is denominated in.
The second currency in the pair. Also known as the terms currency.
USD = US Dollar
EUR = Euro
JPY = Japanese Yen
GBP = British
Pound
CHF = Swiss Franc
CAD = Canadian Dollar
AUD = Australian
Dollar
NZD = New Zealand Dollar
EUR/USD = "Euro"
USD/JPY = "Dollar Yen"
GBP/USD = "Cable" or
"Sterling"
USD/CHF = "Swissy"
USD/CAD = "Dollar Canada" (CAD referred to
as the "Loonie")
AUD/USD = "Aussie Dollar"
NZD/USD = "Kiwi"
Futures Commission Merchant. An individual or organisation licensed by the U.S. Commodities Futures Trading Commission (CFTC) to deal in futures products and accept monies from clients to trade them.
A market maker provides pricing for a particular currency pair and stands ready to buy or sell that pair at the quoted price. A market maker takes the opposite side of your trade and has the option of either holding that position or partially or fully offsetting it with other dealers, managing their aggregate exposure to the market. A market maker earns their commission from the spread between the bid and offer price.
ECN is an acronym for Electronic Communications Network. A Forex ECN broker provides a marketplace where multiple market makers, banks and traders can enter in competing bids and offers into the platform either inside or outside the spread, allowing traders to have their trades filled by multiple liquidity providers. A trader might have their buy order filled by liquidity provider "A", and close the same order against liquidity provider "B", or have the trade filled by the bid or offer of another trader. The best bid and offer is displayed to the trader with the combined available volume displayed at each price. An ECN charges a small fee for each transaction.
A dealing desk provides pricing and liquidity and executes trades.
An acronym for 'No Dealing Desk'. A no-dealing desk broker uses external liquidity providers to provide pricing and liquidity for its clients. The liquidity providers send in competing bids and offers into the platform, resulting in the best bid and offer being displayed to the client.
One of the participants in a transaction.
The sell quote is displayed on the left and is the price at which you can sell the base currency. It is also referred to as the market maker's bid price. For example, if the EUR/USD quotes 1.3200/03, you can sell 1 Euro at the bid price of US$1.3200.
The buy quote is displayed on the right and is the price at which you can buy the base currency. It is also referred to as the market maker's ask or offer price. For example, if the EUR/USD quotes 1.3200/03, you can buy 1 Euro at the offer price of US$1.3203.
The difference between the sell quote and the buy quote or the bid and offer price. For example, if EUR/USD quotes read 1.3200/03, the spread is the difference between 1.3200 and 1.3203, or 3 pips. In order to break even on a trade, a position must move in the direction of the trade by an amount equal to the spread.
The smallest price increment a currency can make. Also known as points. For example, 1 pip = 0.0001 for EUR/USD, or 0.01 for USD/JPY.
The value of a pip. Pip value can be either fixed or variable depending on the currency pair. e.g. The pip value for EUR/USD is always $10 for standard lots, $1 for mini-lots and $0.10 for micro lots.
The standard unit size of a transaction. Typically, one standard lot is equal to 100,000 units of the base currency, 10,000 units if it's a mini, or 1,000 units if it's a micro. Some dealers offer the ability to trade in any unit size, down to as little as 1 unit.
Trading with standard lot sizes, generally 100,000 units of the base currency. e.g. The pip value is $10 for EUR/USD.
Trading with mini lot sizes, generally 10,000 units of the base currency. e.g. The pip value is $1 for EUR/USD.
Trading with micro lot sizes, generally 1,000 units of the base currency. e.g. The pip value is $0.10 for EUR/USD.
The deposit required to open or maintain a position. Margin can be either "free" or "used". Used margin is that amount which is being used to maintain or open a position, whereas free margin is the amount available to open new positions. With a $1,000 margin balance in your account and a 1% margin requirement to open a position, you can buy or sell a position worth up to a notional $100,000. This allows a trader to leverage his account by up to 100 times or a leverage ratio of 100:1. If a traders account falls below the minimum amount required to maintain an open position, he will receive a "margin call" requiring him to either add more money into his or her account or to close the open position. Most brokers will automatically close a traders open positions when the margin balance falls below the amount required to keep the positions open. The amount required to maintain an open position is dependent on the broker and could be 50% of the original margin required to open the trade.
Leverage is the ability to gear your account into a position greater than your total account margin. For instance, if a trader has $1,000 of margin in his account and he opens a $100,000 position, he leverages his account by 100 times, or 100:1. If he opens a $200,000 position with $1,000 of margin in his account, his leverage is 200 times, or 200:1. Increasing your leverage magnifies both gains and losses.
To calculate the leverage used, divide the total value of your open positions by the total margin balance in your account. For example, if you have $10,000 of margin in your account and you open one standard lot of USD/JPY (100,000 units of the base currency) for $100,000, your leverage ratio is 10:1 ($100,000 / $10,000). If you open one standard lot of EUR/USD for $150,000 (100,000 x EURUSD 1.5000) your leverage ratio is 15:1 ($150,000 / $10,000).
An order which is executed by dealer intervention.
The order is executed automatically without dealer intervention or involvement.
The difference between the order price and the executed price, measured in pips. Slippage often occurs in fast moving and volatile markets, or where there is manual execution of trades.
The decline in account balance from peak to valley, until the account surpasses the previous high, usually measured in percentage terms.
Support is a technical price level where buyers outweigh sellers, causing prices to bounce off a temporary price floor.
Resistance is a technical price level where sellers outweigh buyers, causing
prices to bounce off a temporary price ceiling.
Common Order Types
An order to buy or sell at the current market price.
An order to buy or sell at a pre-specified price level.
An order to restrict losses at a pre-specified price level.
An order to buy below the market or sell above the market at a pre-specified level, believing that the price will reverse direction from that point.
An order to buy above the market or sell below the market at a pre-specified level, believing that the price will continue in the same direction.
One Cancels Other. An order whereby if one is executed, the other is cancelled.
Good Till Cancelled. An order stays in the market until it is either filled or cancelled.
Common Trade Types
A position in which the trader attempts to profit from an increase in price. i.e. Buy low, sell high.
A position in which the trader attempts to profit from a decrease in price. i.e. Sell high, buy low.
Common Trading Styles
A style of trading that involves analysing price charts for technical patterns of behaviour.
A style of trading that involves analysing the macroeconomic factors of an economy underpinning the value of a currency and placing trades that support the trader's long or short-term outlook.
A style of trading that attempts to profit from riding short, medium or long term trends in price.
A style of trading that attempts to profit from buying and selling currencies between a lower level of support and an upper level of resistance. The upper level of resistance and the lower level of support defines the range. The range forms a price channel where the price can be seen to oscillate between the two levels of support and resistance.
A style of trading whereby a trader attempts to profit from fundamental news announcements on a country's economy that may affect the value of a currency, usually seeking short term profit immediately after the announcement is released.
A style of trading that involves frequent trading seeking small gains over a very short period of time. Trades can last from seconds to minutes.
A style of trading that involves multiple trades on an intra-day basis. Trades can last from minutes to hours.
A style of trading that involves seeking to profit from short to medium term swings in trend. Trades can last from hours to days.
A style of trading whereby the trader attempts to profit from holding a currency with a higher rate of interest and selling a currency with a lower rate of interest, profiting from the daily interest rate differential of the position.
A style of trading that involves taking a longer term position that reflects a longer term outlook. Trades can last from weeks to months.
A style of trading that uses human judgement and decision making in every trade.
A style of trading that involves neither human decision making nor
involvement, but uses a pre-programmed strategy based on technical or
fundamental analysis to automatically execute trades via an automated software
programme.
Example Trade
Assume you have a trading account at a broker that requires a 1% margin deposit for every trade. The current quote for EUR/USD is 1.3225/28 and you want to place a market order to buy 1 standard lot of 100,000 Euros at 1.3228, for a total value of US$132,280 (100,000 * $1.3228). The broker requires you to deposit 1% of the total, or $1322.80 to open the trade. At the same time you place a take-profit order at 1.3278, 50 pips above your order price. In taking this trade you expect the Euro to strengthen against the U.S. dollar.
As you expected, the Euro strengthens against the U.S. dollar and you take your profit at 1.3278, closing out the trade. As each pip is worth US$10, your total profit for this trade is $500, for a total return of 38%.
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