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Lesson 1

About Forex

Spot Rate

Spot rate is today’s market price of one currency measured in terms of another: for example, the price of one US dollar in Swiss francs. The spot rates of all currencies against the US dollar (USD) are basic ones, the rest are considered cross rates.

Some of the existing currencies are considered major; these include the US Dollar (USD), the Euro (EUR), the British Pound (GBP), the Swiss Franc (CHF) and the Japanese Yen (JPY).

When you ask dealers for a quote, for example EUR/USD, they will give two different prices, e.g. 1.3712 - 1.3714. From the dealer’s perspective, the difference between the two numbers “buy” and “sell” is called a spread. If you want to buy 1 euro, theoretically you have to pay 1.3714 USD for it, but if you want to sell 1 euro, you are going to be paid 1.3712 USD by your dealer. In this case, the difference between “buy” and “sell” (the spread) is equal to 0.0002, or 2 pips. In fact, buying one currency is the action of selling the other. Alternatively, selling one currency actually means that you are buying the other.

Spot Date

The spot date in the foreign exchange market is the normal settlement day for a transaction made today. It normally takes two business days to process all the necessary documents and carry out all transactions, keeping in mind that usually the countries whose currencies take part in the deal may be in different time zones and payments need to be synchronised. The spot date cannot be a Saturday, Sunday or any official holiday in any of the countries. In such cases, the spot date is the next business day.

There is an option for the deal to be negotiated with a value date prior to the spot date - for example, the same day as the transaction date or the next business day. In both cases, the exchange rate will be different from the exchange rate on the spot date - because the two countries have different interest rates.

Direct and Indirect Quotes

On the currency exchange market in every country, the local currency is quoted directly or indirectly against the US dollar and other foreign currencies.

  • The direct quote is the amount of local currency needed to buy one unit of the foreign currency and the amount of local currency, respectively, due to be received when one unit of foreign currency is being sold:

    102.38 – 102.40 USD/JPY

    This means that dealers are buying one dollar for 102.38 yen, but are selling it for 102.40 yen.

  • On the other hand, the indirect quote is the amount of foreign currency needed to buy one unit of the local currency. For instance, the following indirect quote is used for quoting the British Pounds versus the US Dollar:

    1.6680 – 1.6683 GBP/USD

    This means you have to pay 1.6683 USD to buy 1 GBP and if you want to sell 1 GBP, you will receive 1.6680 USD for it.

Quoted and Basic Currencies

The spot exchange rate is the price of one currency in terms of another. In the example above, 102.38 – 102.40 USD/JPY, the USD is the basic currency and the JPY is the quoted currency. This is not the case in our second example, 1.6680 – 1.6683 GBP/USD, where the USD is the quoted currency because it is second in the GBP/USD expression.

Pips and Figures

The following example demonstrates what pips and figures are:

Currencies are quoted using four positions after the decimal point, which means that one pip is 1/10,000 of the currency unit. In the example above, EUR/USD, there is a difference of 4 pips between “buy” and “sell”, but there is no difference in the value of the figures.

This is not the case when the Japanese yen is the quoted currency. Due to the high denomination of the yen against the US dollar, e.g. 102.38 – 102.40, the yen is quoted only two positions after the decimal point. In this case, one pip is equal to 1/100 of the yen.

The dealer will only quote the pip value over the phone, presuming that you are aware of the market and know the value of figures. If you are not sure about the figure, do not hesitate to ask.

Positions

Your main goal on the Forex market is gaining profit from your positions through buying and selling different currencies. For example, you have bought a currency, and this particular currency rises in value. In this case you make profit if you quickly close your position. If you close your position and sell the currency back for fixing your profit, you are in fact buying the counter currency in this pair. That's how a value is being formed - one currency’s value compared to another, when operating with currency pairs. In the end, the currency of any country has a value only when compared to the currency of another country.

A Forex position is a financial commitment to a particular currency. The position can be flat or hedged, long or short. The position is hedged when there's no exposure to risk. It is long if more currency has bought than sold, and it is short if more currency has been sold than bought.

What affects the prices of currencies?

Currency prices (exchange rates) are affected by a variety of economic and political conditions, especially interest rates, inflation and political stability. Moreover, governments sometimes participate in the FX market to influence the value of their currencies, either by flooding the market with their domestic currency in an attempt to lower the price; or conversely, by buying in order to increase the price. This is known as central bank intervention. Any of these factors, as well as some large market orders, can cause high volatility in currency prices. However, the size and volume of the FX market make it impossible for any single participant to “drive” the market in a particular direction.

How do I manage risk when trading currencies?

The most common risk management tools in FX trading are the limit (take profit) profit and the stop loss orders. A limit order places a restriction on the maximum price to be paid or the minimum price to be received. A stop loss order ensures that a particular position is automatically closed at a predetermined price in order to limit potential losses if the market moves against the investor's positions.

Cross Rate Effect: GBP/USD is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/GBP. For instance, a rise in EUR/GBP (fall in sterling), triggered by strengthening expectations of UK’s membership into the Euro, could lead to a decline in GBP/USD (cable). Conversely, reports indicating that the UK may not join the single currency will hurt the EUR/GBP, thereby boosting cable.

What is Balance-of-Payments?

The exchange rate of any foreign currency depends on a multitude of factors that affect the economic and financial conditions in the country issuing the currency. One of the most important factors is the country’s balance-of-payments records. When a country experiences a deficit in its balance of payments, it becomes a net demander of foreign currencies and is forced to sell substantial amounts of its own currency to pay for imports of goods and services. Therefore, balance-of-payments deficits often lead to depreciation of a nation's currency relative to the other currencies.

Why is inflation important?

Inflation has a particularly potent effect on exchange rates, as do differences in real exchange rates between countries. When one country’s inflation rate rises relative to others, its currency tends to fall in value. Similarly, a nation that reduces its inflation rate usually experiences a rise in the value of its currency. Moreover, countries with higher real interest rates generally experience an increase in the exchange rate of their currencies.

Why are central bank interventions necessary?

In today’s shady currency market, active interventions by central banks are highly probable. Major central banks around the world, including the Federal Reserve in the United States and Bundesbank in Germany, may decide that their national currency is declining too rapidly against other key currencies. For instance, if the dollar goes into a rapid decline against the euro, the Federal Reserve is likely to intervene by selling euros and buying dollars in order to stabilise the currency market. In most cases, central bank interventions are only temporary and their aim is to find a new equilibrium level for the currency.

Cross Rates

Non-US dollar currency pairs are known as “crosses.” We can derive cross exchange rates for the GPB, EUR, JPY and CHF from the aforementioned major pairs. Exchange rates must be consistent across all currencies, or it will be possible to “round trip”, or make profits without any risk.

Example: Computing cross rates

Let us presume that the following major exchange rates are valid:

EUR/USD = 1.3712/14
GBP/USD = 1.6680/83
USD/JPY = 102.38/40
USD/CHF = 0.8911/14

Now let us calculate GBP/CHF:

GBP/USD: Buy: 1.6680 / Sell: 1.6683
USD/CHF: 0.8911/0.8914

GBP/USD X USD/CHF = 1.6680 X 0.8911 / 1.6683 X 0.8914


Going Short, Going Long

When you buy a currency, you are said to be “long” in that currency. Long positions are placed at the ”Ask” price. Therefore, if you buy 1 lot GBP/USD lot quoted at 1.66800/83, then you are buying 1000 GBP at 1.6683 USD.

When you sell a currency, you are said to be “short” in that currency. Short positions are entered into at the “Bid” price, which in this case is 1.6680 USD.

Because of symmetry in currency transactions, you are always simultaneously long in one currency and short in another. For example, if you exchange 100,000 GBP for USD, you are short in British punds and long in US dollars.

Closing Out

An open position is one whose value is moving relative to the market movement. Any potential profits and losses will be reflected in your trading account.

To close out your position, you have to place an equal and opposite trade in the same currency pair. For example, if you are holding a long position in 1 lot of GBP/USD, you can close that position by selling 1 lot GBP/USD.

Opening and closing positions must be done through the same broker. You cannot open a GBP/USD position with broker A and close it out through broker B.

Betting on a Rise

Let us assume that you start trading at a current GPB/USD rate of 1.6680/83.

  • You expect the pound to appreciate against the dollar, so you buy 100,000 GBP at 1.6683 USD.
  • The value of the contract is 100,000 X 1.6683 USD = 166,830 USD.
  • The GBP/USD duly appreciates to 1.6700/03 and you decide to close your position by selling your pounds for dollars. Your profit is:
    100,000 X (1.6700 – 1.6683) USD = 170 USD - the equivalent of 10 USD per 1 pip.
  • You earn 170 USD on an exchange rate movement by less than 1%. This illustrates the positive effect of buying on margin.
  • On the other hand, if the GBP/USD falls to 1.665053, your loss will be:

    100,000 X (1.6650 – 1.6683) USD = - 330 USD

The conclusion is that margin trading may magnify the amount of both your profit and loss.

Betting on a Fall

Let us assume that you start trading at a current GPB/USD rate of 1.6680/83.

  • You expect the pound to decline against the dollar, so you sell 100,000 GBP at 1.6683 USD.
  • The value of the contract is 100,000 X 1.6680 USD = 166,800 USD. You have effectively sold 100,000 GBP and bought 166,800 USD.
  • If your broker requires 1% of 166,800 USD as margin, or 1,668.00 USD, and the GBP/USD falls to 1.6642/45, you are looking at a potential profit of:

    100,000 X (1.6680 – 1.6645 USD) = 350 USD

  • However, if the GBP/USD starts to rise and reaches 1.6700/03, you are looking at a potential loss of:

    100,000 X (1.6680 – 1.6703) USD = 230 USD.