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 said to be 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 your dealer for a quote, for example EUR/USD, he will provide you with two different prices, e.g. 1.0643 – 1.0647. The difference between these two numbers, “buy” and “sell” from the dealer’s point of view, is called the spread. If you want to buy one euro, you have to pay, in this hypothetical case, 1.0647 USD for it, but if you want to sell one euro you are going to be paid by your dealer 1.0643 for it. In this case the difference between “buy” and “sell”, or the spread, is 0.0004 or 4 pips. Note that buying one currency is actually the action of selling the other; alternatively, selling one currency actually means that you are buying the other.
Spot date
On the currency exchange market the spot date is two working days after the actual deal. It takes two days to set all the necessary documents and to carry out all the transactions, keeping in mind that usually the countries whose currencies are taking part in the deal are situated in different time zones and the payments have to be synchronized. The spot date cannot be Saturday, Sunday or an official holiday for any of the two countries. In such cases, the spot date is the next working day.
It is possible for the deal to be negotiated with a value date prior to the spot date, for example the same day as the date of the deal or the next day. The first case is with a value date today and the second with a value date tomorrow. In these two cases the exchange rate is different from the exchange rate on the spot date. The difference takes into account the interest rate differential.
Direct and indirect quotes
On the Currency exchange market in every country, the local currency is quoted directly or indirectly against the American dollar and the other foreign currencies.
Quoted and Basic currencies
The spot exchange rate is the price of one currency in terms of another. In the above example, 120.44- 120.52 USD/JPY, the USD is the basic and the JPY is the quoted currency. This is not the case in our second example, 1.3600 – 1.3610 GBP/USD, where the USD is the quoted currency because it is second in the GBP/USD expression.
Pips and Figures
The following example will demonstrate 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 above example, 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 currency being quoted. Due to the high denomination of the yen against the USD, e.g. 121.23 – 121.39, the yen is quoted two positions after the decimal point only. In this case one pip is equal to 1/100 of the Japanese currency unit.
When asked over the phone, the dealer will tell you only the values of the pips, presuming that you are aware of the market and know the value of the figures. If you are not sure about the figure, don’t forget to ask.
Positions
In the Forex market, currencies are always priced in pairs; therefore, all trades result in the simultaneous buying of one currency and the selling of another. The objective of currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold. If you have bought a currency and the price appreciates in value, the trader must sell the currency back in order to lock in the profit. An open trade or position is one in which a trader has either bought/sold one currency pair and has not sold/bought back the equivalent amount to effectively close the position.
What affects the prices of currencies?
Currency prices (exchange rates) are affected by a variety of economic and political conditions, most importantly interest rates, inflation and political stability. Moreover, governments sometimes participate in the Forex 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 raise the price. This is known as Central Bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. However, the size and volume of the Forex market makes it impossible for any one entity to “drive” the market for any length of time.
How do I manage risk when I trade currencies?
The most common risk management tools in Forex trading are the limit order and the stop loss order. A limit order places restriction on the maximum price to be paid or the minimum price to be received. A stop loss order ensures a particular position is automatically liquidated at a predetermined price in order to limit potential losses should the market move against an investor's position. The liquidity of the Forex market ensures that limit order and stop loss orders can be easily executed.
Key fundamentals impacting the US dollar
Federal Reserve Bank (Fed): The US Central Bank has full independence in setting monetary policy to achieve maximum non-inflationary growth. The Fed’s chief policy signals are: open market operations, the Discount Rate and the Fed Funds rate.
Federal Open Market Committee (FOMC): The FOMC is responsible for making decisions on monetary policy, including the crucial interest rate announcements it makes eight times per year. The 12-member committee is made up of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the remaining four seats carry a one-year term each in a rotating selection of the presidents of the 11 other Reserve Banks.
Interest Rates: Fed Funds Rate: Clearly the most important interest rate. It is the rate that depositary institutions charge each other for overnight loans. The Fed announces changes in the Fed Funds rate when it wishes to send clear monetary policy signals. These announcements normally have a large impact on all stock, bond and currency markets.
Discount Rate: The interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always less than the Fed Funds Rate.
30-year Treasury Bond: The 30-year US Treasury Bond, also known as the long bond, or bellwether treasury. It is the most important indicator of markets’ expectations on inflation. Markets most commonly use the yield (rather than the price) when referring to the level of the bond. As in all bonds, the yield on the 30-year treasury is inversely related to the price. There is no clear-cut relationship between the long bond and the US dollar. But the following usually holds: A fall in the value of the bond (a rise in the yield) due to inflationary concerns may put pressure on the dollar. These concerns could arise from strong economic data.
Nevertheless, as the supply of 30-year bonds began to shrink following the US Treasury's refunding operations (buying back its debt), the 30-year bond’s role as a benchmark had gradually given way to its ten-year counterpart. Depending on the stage of the economic cycle, strong economic data could have varying impacts on the dollar. In an environment where inflation is not a threat, strong economic data may boost the dollar. But at times when the threat of inflation (higher interest rates) is most urgent, strong data normally hurts the dollar because of the resulting sell-off in bonds.
Being a benchmark asset-class, the long bond is normally impacted by shifting capital flows triggered by global considerations. Financial/political turmoil in emerging markets could be a possible booster for US treasuries due to their safe character, thereby helping the dollar.
Three-month Eurodollar Deposits: Eurodollar deposits are bank accounts deposited in a country other than the country of the currency. For example, Japanese yen accounts deposited outside Japan are called “euroyen.” Similarly, euro-denominated accounts deposited outside the eurozone are called “euroEuros.” The interest rate on three-month dollar-denominated deposits is held in banks outside the US. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. To illustrate USD/JPY as a theoretical example, the greater the interest rate differential in favor of the eurodollar against the euroyen deposit, the more likely USD/JPY will receive a boost. Sometimes, this relation does not hold due to the confluence of other factors.
Ten-year Treasury Note: FX markets usually refer to the ten-year note when comparing its yield with that on similar bonds overseas, namely the euro (German ten-year bund), Japan (ten-year JGB) and the UK (ten-year gilt). The spread differential (difference in yields) between the yield on ten-year US Treasury notes and that on non-US bonds impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies.
Treasury: The US Treasury is responsible for issuing government debt and for making decisions on the fiscal budget. The Treasury has no say in monetary policy, but its statements on the dollar have a major influence on the currency.
Economic Data: The most important economic data items released in the US are: Labor reports (payrolls, unemployment rate and average hourly earnings), CPI, PPI, GDP, international trade, ECI, NAPM, productivity, industrial production, housing starts, housing permits, and consumer confidence.
Stock Market: The three major stock indices are the Dow Jones Industrials Index (Dow), S&P 500, and NASDAQ. The Dow is the most influential index on the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the greenback as foreign investors purchased US equities. Three major forces affect the Dow: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations; and 3) Global considerations. Consequently, these factors channel their way through the dollar.
Cross Rate Effect: TheThe dollar’s value against one currency is sometimes impacted by another currency pair (exchange rate) that may not involve the dollar. To illustrate, a sharp rise in the yen against the euro (falling EUR/JPY) could cause a general decline in the euro, including a fall in EUR/USD.
Fed Funds Rate Futures Contract: Interest rate expectations can be made through the Fed Funds rate in the futures market. The contract’s value shows what the Fed Funds interest rate (overnight rate) is expected to be in the future, depending on the maturity of the contract. Hence, the contract is a valuable barometer of market expectation vis-à-vis Federal Reserve policy. The rate is obtained by subtracting the contract’s value from 100 and comparing the result to the prevailing Fed Funds rate in the cash/spot market.
Three-month Eurodollar Futures Contract: While the Fed Funds futures contract reflects Fed Funds rate expectations into the future, the three-month eurodollar contract does the same for the interest rate on three-month eurodollar deposits. To illustrate, the difference between futures contracts on the three-month eurodollar and euroyen deposits is an essential variable in determining USD/JPY expectations.
Factors affecting USD/JPY
Ministry of Finance: The MoF is the single most important political and monetary institution in Japan. Its influence in guiding the currency is more significant than the ministries of finance of the US, UK or Germany, despite the gradual measures to decentralize decision-making. MoF officials often make statements regarding the economy that have notable impacts on the yen. These statements include verbal intervention aimed at avoiding undesirable appreciation/depreciation of the yen.
Bank of Japan (BoJ): InIn 1998, Japan passed new laws giving the central Bank (BoJ) operational independence from the government (MoF). While complete control over monetary policy has shifted to the BoJ, the MoF remains in charge of foreign exchange policy.
Interest Rates: The Overnight Call Rate is the key short-term interbank rate. The call rate is controlled by the BoJ’s open market operations designed to manage liquidity. The BoJ uses the call rate to signal monetary policy changes that impact the currency.
Japanese Government Bonds (JGBs): The BoJ buys ten- and 20-year JGBs every month to inject liquidity into the monetary system. The yield on the benchmark ten-year JGB serves as a key indicator of long-term interest rates. The spread, or the difference between ten-year JGB yields and those on US ten-year treasury notes is an important driver of the USD/JPY exchange rates. Falling JGBs (rising JGB yields) usually boost the yen and impact USD/JPY.
Economic and Fiscal Policy Agency: Officially replaces the powerful Economic Planning Agency (EPA) on January 6, 2001. It is a government agency responsible for formulating economic planning programs and coordinating economic policies including employment, international trade, and foreign exchange.
Ministry of International Trade and Industry (MITI): A government institution aimed at supporting the interests of Japanese industry and defending the international trade competitiveness of Japanese corporations. The MITI’s power and visibility is not as significant as it used to be in the 1980s and early 1990s, when US-Japan trade issues were the “hottest” topic in FX markets.
Economic Data: The most important economic data items from Japan are: GDP, Tankan survey (quarterly business sentiment and expectations survey), international trade, unemployment, industrial production, and money supply (M2+CDs).
Nikkei-225: Japan’s leading stock index. A reasonable decline in the yen usually lifts stocks of export-oriented companies, which tends to boost the overall stock index. The Nikkei-yen relationship is sometimes reversed, where a strong open market in the Nikkei tends to boost the yen (weighs on USD/JPY) as investors’ funds flow into yen-denominated stocks.
Cross Rate Effect: The USD/JPY exchange rate is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/JPY. To illustrate: A rising USD/JPY (rising dollar and a falling yen) could be the result of an appreciating EUR/JPY, rather than direct strength in the dollar. This rise in the cross rate could be highlighted due to contrasting sentiment between Japan and the eurozone.
Another example: Both EUR/JPY and EUR/USD rally because of a general strengthening in the euro. For some particular factors (such as better prospects in Japan), this could have a larger impact on the dollar than it does on the yen. As a result, USD/JPY weakens since the yen is relatively less hurt by the appreciating euro.
Factors affecting EUR/USD
The Eurozone: The 12 countries that have adopted the euro in order of GDP: Germany, France, Italy, Spain, the Netherlands, Belgium, Austria, Finland, Portugal, Ireland, Luxembourg and Greece.
European Central Bank: Controls monetary policy for the eurozone. The decision-making body is the Governing Council, which consists of the Executive Board and the governors of the national central banks. The Executive Board consists of the ECB President, Vice-President, and four other members:
ECB Policy Targets: The primary objective of ECB is price stability. It has two main "pillars" of monetary policy: The first one is the outlook for price developments and risks to price stability. Price stability is defined as an increase of the Harmonized Index of Consumer Prices (HICP) of below 2%. While the HICP is important, a broad number of indicators and forecasts are used to determine the medium-term threat to price stability. The second pillar is monetary growth as measured by M3. The ECB has a "reference value" of 4.5% annual growth for M3.
The ECB holds a Council meeting every other Thursday to make announcements on interest rates. At each first meeting of the month, the ECB holds a press conference in which it gives its outlook on monetary policy and the economy as a whole.
Interest Rates: The ECB’s refinancing rate is the Bank’s key short-term interest rate used for managing liquidity. The difference between the refinancing rate and the US Fed Funds rate is a good indicator for the EUR/USD.
Three-month Eurodeposit (Euribor): Eurodollar deposits are bank accounts deposited in a country other than the country of the currency; e.g. Japanese Yen accounts deposited outside Japan are called “euroyen.” Similarly, euro-denominated accounts deposited outside the eurozone are called "euroEuros". The interest rate on three-month euribor deposits held in banks outside the eurozone. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Using a theoretical example on EUR/USD, the greater the interest rate differential in favor of the euribor against the eurodollar deposit, the more likely EUR/USD is to rise. Sometimes, this relation does not hold due to the confluence of other factors.
Ten-Year Government Bonds: Another important driver of the EUR/USD exchange rate is the difference in interest rates between the US and the eurozone. The German ten-year Bund is normally used as the benchmark. Since the rate on the ten-year Bund is below that of the US ten-year note, a narrowing of the spread (i.e. a rise in German yields or a fall in US yields or both) is theoretically expected to favor the EUR/USD rate. A widening in the spread will act against the exchange rate. So the ten-year US-German spread is a good number to be aware of. The trend in this number is usually more important than the absolute value. Naturally, the interest rate differential is usually related to the growth outlook of the US and the eurozone, which is another fundamental driver of the exchange rate.
Economic Data: The most important economic data is from Germany, the largest economy, and from the euro-wide statistics still in their infancy. The key data are usually GDP, inflation (CPI and HICP), Industrial Production, and Unemployment. From Germany in particular, a key piece of data is the IFO survey, which is a widely watched indicator of business confidence. Also important are the budget deficits of the individual countries, which according to the Stability and Growth Pact, must be kept below 3% of GDP. Countries also have targets for reducing their deficits further; failure to meet these targets will likely be detrimental to the euro (as we saw with Italy’s loosening of its budget deficit guidelines).
Cross Rate Effect: The EUR/USD exchange rate is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/JPY or EUR/JPY. To illustrate: EUR/USD could fall as a result of significantly positive news in Japan that filters through a falling EUR/JPY rate. Even though, USD/JPY may be declining, euro weakness spills onto a falling EUR/USD.
Three-month Euro Futures Contract (Euribor): The contract reflects market expectations on three-month euroEuro deposits (euribor) into the future. The difference between futures contracts on the three-month cash eurodollar and on the euroEuro deposit is an essential variable in determining EUR/USD expectations.
Other Indicators: There is a strong negative correlation between EUR/USD and USD/CHF, reflecting a steadily similar relationship between the euro and the Swiss franc. This is because the Swiss economy is largely dependent upon the eurozone economies. In most cases, a spike (dip) in EUR/USD is accompanied by a dip (spike) in EUR/CHF. The inverse also usually holds. This relationship sometimes fails to hold in the event of data or factors pertaining solely to either of the currencies.
Political Factors: As with all exchange rates, EUR/USD is susceptible to political instability such as a threat to coalition governments in France, Germany or Italy. Political or financial instability in Russia is also a red flag for EUR/USD because of the substantial amount of German investment in Russia.
Factors affecting GBP/USD (Cable)
Bank of England (BoE): Under the Bank of England Act of June 1997, the BoE obtained operational independence in setting monetary policy to deliver price stability and to support the government’s growth and employment objectives. The price stability objective is set by the government's inflation target, defined as 2.5% annual growth in Retail Prices Index excluding mortgages (RPI-X). Hence, despite its independence in setting monetary policy, the BoE remains dependent on having to meet the inflation target set by the Treasury.
Monetary Policy Committee(MPC): The BoE's Committee responsible for making decisions on interest rates.
Interest Rates: The Central Bank's main interest rate is the minimum lending rate (base rate), which it uses to send clear signals on monetary policy changes in the first week of every month. Changes in the base rate usually have a large impact on sterling. The BoE also sets monetary policy through its daily market operations used to change the dealing rates at which it buys government bills from discount houses (specialized institutions in trading money market instruments).
Gilts: Government bonds known as gilt-edged securities. The spread differential (difference in yields) between the yield on the ten-year gilt and that on the ten-year US Treasury note usually impacts the exchange rate. The spread differential between gilts and German bunds is also important, as it impacts the EUR/GBP exchange rate, which could affect GBP/USD (see cross-rate effect).
Three-month Eurosterling Deposits: Eurodollar deposits are bank accounts deposited in a country other than the country of the currency; e.g. Japanese yen accounts deposited outside Japan are called "euroyen". Similarly, euro-denominated accounts deposited outside the eurozone are called "EuroEuros". The interest rate on three-month sterling-denominated deposits held in banks outside the UK. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Using a theoretical example on GBP/USD, the greater the interest rate differential in favor of the eurodollar against the eurosterling deposit, the more likely GBP/USD is to fall. Sometimes, this relation does not hold due to the confluence of other factors.
Treasury: The Treasury’s role in setting monetary policy diminished markedly since the Bank of England Act of June 1997. Nevertheless, the Treasury still sets the inflation target for the BoE and makes key appointments at the Central Bank.
Economic Data: The most important economic data items released in the UK are: The claimant unemployment (number of unemployed), claimant unemployment rate, average earnings, RPI-X, retail sales, supply (M4), balance of payments, and housing prices.
Three-month Eurosterling Futures Contract (short sterling): The contract reflects market expectations on three-month eurosterling into the future. The difference between futures contracts on the three-month eurodollar and eurosterling deposits is an essential variable in determining GBP/USD expectations.
FTSE-100: Britain's leading stock index. Unlike in the US or Japan, Britain’s main stock index has relatively less influence on the currency. Nevertheless, the positive correlation between the FTSE-100 and the Dow Jones Industrial Index is one of the strongest in the global markets.
Cross Rate Effect: GBP/USD is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/GBP. To illustrate: A rise in EUR/GBP (fall in sterling), triggered by strengthening expectations of UK 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 project will hurt the EUR/GBP, thereby boosting cable.
What is Balance-of-Payments Position?
The exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. One of the most important factors is the status of a nation’s balance-of-payments position. 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 top price depreciation of a nation's currency relative to the prices of other currencies.
Why is inflation important?
Inflation has a particularly potent effect on exchange rates, as do differences in real exchange rates between nations. When one nation’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 value of their currencies.
Why are Central Bank interventions important?
Overshadowing the currency market today is the ever-present possibility that central banks will become active participants. Major central banks around the world, including the Federal Reserve System in the United States and the Bundesbank in Germany, may decide on a given day that their national currency is declining too rapidly in value relative to other key currencies. Thus, if the dollar falls precipitously against the German mark, support operations by the Federal Reserve System in the form of heavy sales of marks and corresponding purchases of dollars may be employed to stabilize the currency markets. Usually, central bank intervention is temporary, designed to promote a smooth adjustment in currency values toward a new equilibrium level rather than to permanently prop up a weak currency.
Cross rates
Pairings of non-US dollar currencies 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 else it will be possible to “round trip” and make profits without risk.
Computing cross rates – an example
Assume that the following major exchange rates are known:
EUR/USD = 1.0060/65
GBP/USD = 1.5847/52
USD/JPY = 120.25/30
USD/CHF = 1.4554/59
To calculate GPB/CHF
GBP/USD: Bid: 1.5847 Offer: 1.5852
USD/CHF: 1.4554 1.4559
GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559
Going short – going long
When you buy a currency, you are said to be “long” in that currency. Long positions are entered into at the offer price. Thus, if you are buying one GBP/USD lot quoted at 1.5847/52, then you will buy 100,000 GBP at 1.5852 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 is 1.5847 USD in our example.
Because of the symmetry of 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 sterling and long in US dollars.
Closing out
An open position is one that is live and ongoing. As long as the position is open, its value will fluctuate in accordance with the exchange rate in the market. Any profits and losses will exist on paper only and will be reflected in your margin account.
To close out your position, you conduct an equal and opposite trade in the same currency pair. For example, if you have gone long in one lot of GBP/USD (at the prevailing offer price) you can close out that position by subsequently going short in one GBP/USD lot (at the prevailing bid price).
Your opening and closing trades must be conducted through the same intermediary. You cannot open a GBP/USD position with Broker A and close it out through Broker B.
Betting on a rise
Assume that you start with a clean slate and that the current GPB/USD rate is 1.5847/52.
You expect sterling to fall from GBP/USD = 1.5847/52 so you decide to sell 100,000 GBP/USD.
Fundamental and Technical analysis
Without the apparatus for making sense of the currency market, any trade represents a pure gamble. There are two broad schools of analysis, which are not mutually exclusive.
Fundamental analysis:
Fundamental analysis is the application of the micro and macroeconomic theory to markets, with the aim of predicting future trends. So what fundamental forces drive currency markets?
Balance of trade: Currencies that are associated with long-term trade surpluses will tend to strengthen against those associated with persistent deficits, simply because there is net buying of surplus currencies corresponding to the excess of exports over imports. Trends are important too. An improving balance of trade should cause the relevant currency to appreciate relative to those associated with a deteriorating or stable balance of trade.
Relative inflation rates: If country A is suffering a higher rate of price inflation than country B, then A’s currency ought to weaken relative to B’s in order to restore “purchasing power parity.”
Interest rates: International capital flows seek the highest inflation-adjusted returns, creating additional demand for high real interest-rate currencies and pushing up their rates of exchange.
Expectations and speculation: Markets anticipate events. Speculation on, say, the future rate of inflation may be enough to move the exchange rate, long before the actual trend becomes apparent.
It should be understood that these economic forces act in concert. It is a supremely difficult task, however, to establish where the sum of interacting economic forces will take the market. The solution, some argue, lies in technical analysis.
Technical analysis
Technical analysis is concerned with predicting future price trends from historical price and volume data. The underlying axiom of technical analysis is that all fundamentals (including expectations) are factored into the market and are reflected in exchange rates.
The tools of technical analysis are now freely available to private investors in support of their trading decisions. It cannot be overly stressed, however, that such tools are only estimators and are not infallible.
The following is the briefest of introductions to the technical analytical tools used to identify trends and recurring patterns in a volatile marketplace. Aspiring Forex dealers are advised to undergo proper training in technical analysis, although true proficiency comes with practice, endurance, and experience.
Charts
Line Chart: AA graphic depiction of the exchange rate history of any currency pair over time. The line is constructed by connecting up daily closing prices.
Bar chart: A depiction of the price performance of the currency pair, made up of vertical bars at set intra-day time intervals (e.g. every 30 minutes). Each bar has four “hooks,” representing the opening, closing, high and low (OCHL) exchange rates for that time interval.
Candlestick chart: AA variant of the bar chart except that it depicts OCHL prices as “candlesticks” with a wick at each end. Where the opening rate is higher than the closing rate the candlestick is “solid”. Where the closing rate exceeds the opening rate, the candlestick is “hollow.”
Support, resistance, channels, and triangles
Support and resistance thresholds are common features of all tradable financial commodities, including currencies. Breaches of such thresholds are taken as evidence of a fundamental change in market sentiment towards a currency.
Support and resistance often form coherent patterns over time in the shape of channels.
Support
A support level is detected if you can connect up several under-points of the exchange rate cycle on a straight line. This is taken to indicate market reluctance to sell below certain rates of exchange. The more under-points that can be connected, the more evidence there is of a support level.
The support level may change with the passage of time. If the straight line inclines upwards then we speak of “upward support.” Where the line is horizontal we identify “sideways support.” Where the line slopes downwards we diagnose “downward support.”
Resistance
Resistance levels indicate a reluctance to buy a currency above given exchange rates. A resistance level is detected if it is possible to connect a succession of upper points in the exchange rate cycle with a single straight line.
As you would expect, one encounters upward, sideways, and downward resistance.
Channels are identified by superimposing support and resistance levels on a single line chart. Channels can slope upward, sideways or downward.
Triangles
Where resistance and support lines converge towards one another over time, “triangles” are formed which can be upward, sideways or downward sloping.
Triangles indicate declining profitability over time. Resistance and support levels superimposed on a chart will help predict the time of convergence. What we are seeking are “breakouts” that could go in either direction and which are likely to be “explosive,” presenting opportunities for profitable trading.
The slope of the triangle and the behavior of the pricing cycle in the approach to the predicted intersection of resistance and support may indicate the likely direction of the breakout. For example, if the exchange rate cycle is in a clear upward phase, the breakout is likely to be upwards too. There are some real opportunities here, but also much risk.
Indicators
Moving averages
Moving averages smooth out the peaks and troughs of the exchange rate cycle over a rolling period and indicate the presence of a trend.
There are two main types of moving averages:
Simple: Where past and present data are assumed to be of equal importance and are weighted equally.
Weighted: Where current data is considered more important than past data and is weighted more heavily. The weighting factor takes the form of a “smoothing constant” that increases exponentially over time.
If prices lie below two or more moving averages, this is taken as a bearish signal, and vice versa.
Stochastic oscillators
Stochastic oscillators are momentum indicators that purport to tell you when to buy or sell. They are composed of two elements:
When the oscillator touches 80, the currency is considered overbought. An oscillator below 20 is considered to indicate an oversold currency.
Some of the existing currencies are said to be 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 your dealer for a quote, for example EUR/USD, he will provide you with two different prices, e.g. 1.0643 – 1.0647. The difference between these two numbers, “buy” and “sell” from the dealer’s point of view, is called the spread. If you want to buy one euro, you have to pay, in this hypothetical case, 1.0647 USD for it, but if you want to sell one euro you are going to be paid by your dealer 1.0643 for it. In this case the difference between “buy” and “sell”, or the spread, is 0.0004 or 4 pips. Note that buying one currency is actually the action of selling the other; alternatively, selling one currency actually means that you are buying the other.
On the currency exchange market the spot date is two working days after the actual deal. It takes two days to set all the necessary documents and to carry out all the transactions, keeping in mind that usually the countries whose currencies are taking part in the deal are situated in different time zones and the payments have to be synchronized. The spot date cannot be Saturday, Sunday or an official holiday for any of the two countries. In such cases, the spot date is the next working day.
It is possible for the deal to be negotiated with a value date prior to the spot date, for example the same day as the date of the deal or the next day. The first case is with a value date today and the second with a value date tomorrow. In these two cases the exchange rate is different from the exchange rate on the spot date. The difference takes into account the interest rate differential.
On the Currency exchange market in every country, the local currency is quoted directly or indirectly against the American dollar and the other foreign currencies.
- The direct quoting is the amount of the local currency that is needed to buy one unit of the foreign currency and respectively the amount of local currency that is due to be received when one unit of foreign currency is being sold. In Japan, for example:
120.44- 120.52 USD/JPY
signifies that the dealers are buying one dollar for 120.44 yen, but are selling the very same unit for 120.52 yen.
- Alternatively the indirect quote is the amount of the foreign currency needed to buy one unit of the local currency. The amount of foreign currency that is received if one local currency unit is sold to a dealer. This type of indirect quote is used for British pounds versus the US dollar, for example:
1.3600 – 1.3610 GBP/USD
This means, that you have to pay 1.3610 USD to buy 1 GBP and if you want to sell 1 GBP, you will receive 1.3600 USD for it.
The spot exchange rate is the price of one currency in terms of another. In the above example, 120.44- 120.52 USD/JPY, the USD is the basic and the JPY is the quoted currency. This is not the case in our second example, 1.3600 – 1.3610 GBP/USD, where the USD is the quoted currency because it is second in the GBP/USD expression.
The following example will demonstrate what pips and figures are:
This is not the case when the Japanese yen is the currency being quoted. Due to the high denomination of the yen against the USD, e.g. 121.23 – 121.39, the yen is quoted two positions after the decimal point only. In this case one pip is equal to 1/100 of the Japanese currency unit.
When asked over the phone, the dealer will tell you only the values of the pips, presuming that you are aware of the market and know the value of the figures. If you are not sure about the figure, don’t forget to ask.
In the Forex market, currencies are always priced in pairs; therefore, all trades result in the simultaneous buying of one currency and the selling of another. The objective of currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold. If you have bought a currency and the price appreciates in value, the trader must sell the currency back in order to lock in the profit. An open trade or position is one in which a trader has either bought/sold one currency pair and has not sold/bought back the equivalent amount to effectively close the position.
Currency prices (exchange rates) are affected by a variety of economic and political conditions, most importantly interest rates, inflation and political stability. Moreover, governments sometimes participate in the Forex 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 raise the price. This is known as Central Bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. However, the size and volume of the Forex market makes it impossible for any one entity to “drive” the market for any length of time.
The most common risk management tools in Forex trading are the limit order and the stop loss order. A limit order places restriction on the maximum price to be paid or the minimum price to be received. A stop loss order ensures a particular position is automatically liquidated at a predetermined price in order to limit potential losses should the market move against an investor's position. The liquidity of the Forex market ensures that limit order and stop loss orders can be easily executed.
Federal Reserve Bank (Fed): The US Central Bank has full independence in setting monetary policy to achieve maximum non-inflationary growth. The Fed’s chief policy signals are: open market operations, the Discount Rate and the Fed Funds rate.
Federal Open Market Committee (FOMC): The FOMC is responsible for making decisions on monetary policy, including the crucial interest rate announcements it makes eight times per year. The 12-member committee is made up of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the remaining four seats carry a one-year term each in a rotating selection of the presidents of the 11 other Reserve Banks.
Interest Rates: Fed Funds Rate: Clearly the most important interest rate. It is the rate that depositary institutions charge each other for overnight loans. The Fed announces changes in the Fed Funds rate when it wishes to send clear monetary policy signals. These announcements normally have a large impact on all stock, bond and currency markets.
Discount Rate: The interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always less than the Fed Funds Rate.
30-year Treasury Bond: The 30-year US Treasury Bond, also known as the long bond, or bellwether treasury. It is the most important indicator of markets’ expectations on inflation. Markets most commonly use the yield (rather than the price) when referring to the level of the bond. As in all bonds, the yield on the 30-year treasury is inversely related to the price. There is no clear-cut relationship between the long bond and the US dollar. But the following usually holds: A fall in the value of the bond (a rise in the yield) due to inflationary concerns may put pressure on the dollar. These concerns could arise from strong economic data.
Nevertheless, as the supply of 30-year bonds began to shrink following the US Treasury's refunding operations (buying back its debt), the 30-year bond’s role as a benchmark had gradually given way to its ten-year counterpart. Depending on the stage of the economic cycle, strong economic data could have varying impacts on the dollar. In an environment where inflation is not a threat, strong economic data may boost the dollar. But at times when the threat of inflation (higher interest rates) is most urgent, strong data normally hurts the dollar because of the resulting sell-off in bonds.
Being a benchmark asset-class, the long bond is normally impacted by shifting capital flows triggered by global considerations. Financial/political turmoil in emerging markets could be a possible booster for US treasuries due to their safe character, thereby helping the dollar.
Three-month Eurodollar Deposits: Eurodollar deposits are bank accounts deposited in a country other than the country of the currency. For example, Japanese yen accounts deposited outside Japan are called “euroyen.” Similarly, euro-denominated accounts deposited outside the eurozone are called “euroEuros.” The interest rate on three-month dollar-denominated deposits is held in banks outside the US. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. To illustrate USD/JPY as a theoretical example, the greater the interest rate differential in favor of the eurodollar against the euroyen deposit, the more likely USD/JPY will receive a boost. Sometimes, this relation does not hold due to the confluence of other factors.
Ten-year Treasury Note: FX markets usually refer to the ten-year note when comparing its yield with that on similar bonds overseas, namely the euro (German ten-year bund), Japan (ten-year JGB) and the UK (ten-year gilt). The spread differential (difference in yields) between the yield on ten-year US Treasury notes and that on non-US bonds impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies.
Treasury: The US Treasury is responsible for issuing government debt and for making decisions on the fiscal budget. The Treasury has no say in monetary policy, but its statements on the dollar have a major influence on the currency.
Economic Data: The most important economic data items released in the US are: Labor reports (payrolls, unemployment rate and average hourly earnings), CPI, PPI, GDP, international trade, ECI, NAPM, productivity, industrial production, housing starts, housing permits, and consumer confidence.
Stock Market: The three major stock indices are the Dow Jones Industrials Index (Dow), S&P 500, and NASDAQ. The Dow is the most influential index on the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the greenback as foreign investors purchased US equities. Three major forces affect the Dow: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations; and 3) Global considerations. Consequently, these factors channel their way through the dollar.
Cross Rate Effect: TheThe dollar’s value against one currency is sometimes impacted by another currency pair (exchange rate) that may not involve the dollar. To illustrate, a sharp rise in the yen against the euro (falling EUR/JPY) could cause a general decline in the euro, including a fall in EUR/USD.
Fed Funds Rate Futures Contract: Interest rate expectations can be made through the Fed Funds rate in the futures market. The contract’s value shows what the Fed Funds interest rate (overnight rate) is expected to be in the future, depending on the maturity of the contract. Hence, the contract is a valuable barometer of market expectation vis-à-vis Federal Reserve policy. The rate is obtained by subtracting the contract’s value from 100 and comparing the result to the prevailing Fed Funds rate in the cash/spot market.
Three-month Eurodollar Futures Contract: While the Fed Funds futures contract reflects Fed Funds rate expectations into the future, the three-month eurodollar contract does the same for the interest rate on three-month eurodollar deposits. To illustrate, the difference between futures contracts on the three-month eurodollar and euroyen deposits is an essential variable in determining USD/JPY expectations.
Ministry of Finance: The MoF is the single most important political and monetary institution in Japan. Its influence in guiding the currency is more significant than the ministries of finance of the US, UK or Germany, despite the gradual measures to decentralize decision-making. MoF officials often make statements regarding the economy that have notable impacts on the yen. These statements include verbal intervention aimed at avoiding undesirable appreciation/depreciation of the yen.
Bank of Japan (BoJ): InIn 1998, Japan passed new laws giving the central Bank (BoJ) operational independence from the government (MoF). While complete control over monetary policy has shifted to the BoJ, the MoF remains in charge of foreign exchange policy.
Interest Rates: The Overnight Call Rate is the key short-term interbank rate. The call rate is controlled by the BoJ’s open market operations designed to manage liquidity. The BoJ uses the call rate to signal monetary policy changes that impact the currency.
Japanese Government Bonds (JGBs): The BoJ buys ten- and 20-year JGBs every month to inject liquidity into the monetary system. The yield on the benchmark ten-year JGB serves as a key indicator of long-term interest rates. The spread, or the difference between ten-year JGB yields and those on US ten-year treasury notes is an important driver of the USD/JPY exchange rates. Falling JGBs (rising JGB yields) usually boost the yen and impact USD/JPY.
Economic and Fiscal Policy Agency: Officially replaces the powerful Economic Planning Agency (EPA) on January 6, 2001. It is a government agency responsible for formulating economic planning programs and coordinating economic policies including employment, international trade, and foreign exchange.
Ministry of International Trade and Industry (MITI): A government institution aimed at supporting the interests of Japanese industry and defending the international trade competitiveness of Japanese corporations. The MITI’s power and visibility is not as significant as it used to be in the 1980s and early 1990s, when US-Japan trade issues were the “hottest” topic in FX markets.
Economic Data: The most important economic data items from Japan are: GDP, Tankan survey (quarterly business sentiment and expectations survey), international trade, unemployment, industrial production, and money supply (M2+CDs).
Nikkei-225: Japan’s leading stock index. A reasonable decline in the yen usually lifts stocks of export-oriented companies, which tends to boost the overall stock index. The Nikkei-yen relationship is sometimes reversed, where a strong open market in the Nikkei tends to boost the yen (weighs on USD/JPY) as investors’ funds flow into yen-denominated stocks.
Cross Rate Effect: The USD/JPY exchange rate is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/JPY. To illustrate: A rising USD/JPY (rising dollar and a falling yen) could be the result of an appreciating EUR/JPY, rather than direct strength in the dollar. This rise in the cross rate could be highlighted due to contrasting sentiment between Japan and the eurozone.
Another example: Both EUR/JPY and EUR/USD rally because of a general strengthening in the euro. For some particular factors (such as better prospects in Japan), this could have a larger impact on the dollar than it does on the yen. As a result, USD/JPY weakens since the yen is relatively less hurt by the appreciating euro.
The Eurozone: The 12 countries that have adopted the euro in order of GDP: Germany, France, Italy, Spain, the Netherlands, Belgium, Austria, Finland, Portugal, Ireland, Luxembourg and Greece.
European Central Bank: Controls monetary policy for the eurozone. The decision-making body is the Governing Council, which consists of the Executive Board and the governors of the national central banks. The Executive Board consists of the ECB President, Vice-President, and four other members:
ECB Policy Targets: The primary objective of ECB is price stability. It has two main "pillars" of monetary policy: The first one is the outlook for price developments and risks to price stability. Price stability is defined as an increase of the Harmonized Index of Consumer Prices (HICP) of below 2%. While the HICP is important, a broad number of indicators and forecasts are used to determine the medium-term threat to price stability. The second pillar is monetary growth as measured by M3. The ECB has a "reference value" of 4.5% annual growth for M3.
The ECB holds a Council meeting every other Thursday to make announcements on interest rates. At each first meeting of the month, the ECB holds a press conference in which it gives its outlook on monetary policy and the economy as a whole.
Interest Rates: The ECB’s refinancing rate is the Bank’s key short-term interest rate used for managing liquidity. The difference between the refinancing rate and the US Fed Funds rate is a good indicator for the EUR/USD.
Three-month Eurodeposit (Euribor): Eurodollar deposits are bank accounts deposited in a country other than the country of the currency; e.g. Japanese Yen accounts deposited outside Japan are called “euroyen.” Similarly, euro-denominated accounts deposited outside the eurozone are called "euroEuros". The interest rate on three-month euribor deposits held in banks outside the eurozone. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Using a theoretical example on EUR/USD, the greater the interest rate differential in favor of the euribor against the eurodollar deposit, the more likely EUR/USD is to rise. Sometimes, this relation does not hold due to the confluence of other factors.
Ten-Year Government Bonds: Another important driver of the EUR/USD exchange rate is the difference in interest rates between the US and the eurozone. The German ten-year Bund is normally used as the benchmark. Since the rate on the ten-year Bund is below that of the US ten-year note, a narrowing of the spread (i.e. a rise in German yields or a fall in US yields or both) is theoretically expected to favor the EUR/USD rate. A widening in the spread will act against the exchange rate. So the ten-year US-German spread is a good number to be aware of. The trend in this number is usually more important than the absolute value. Naturally, the interest rate differential is usually related to the growth outlook of the US and the eurozone, which is another fundamental driver of the exchange rate.
Economic Data: The most important economic data is from Germany, the largest economy, and from the euro-wide statistics still in their infancy. The key data are usually GDP, inflation (CPI and HICP), Industrial Production, and Unemployment. From Germany in particular, a key piece of data is the IFO survey, which is a widely watched indicator of business confidence. Also important are the budget deficits of the individual countries, which according to the Stability and Growth Pact, must be kept below 3% of GDP. Countries also have targets for reducing their deficits further; failure to meet these targets will likely be detrimental to the euro (as we saw with Italy’s loosening of its budget deficit guidelines).
Cross Rate Effect: The EUR/USD exchange rate is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/JPY or EUR/JPY. To illustrate: EUR/USD could fall as a result of significantly positive news in Japan that filters through a falling EUR/JPY rate. Even though, USD/JPY may be declining, euro weakness spills onto a falling EUR/USD.
Three-month Euro Futures Contract (Euribor): The contract reflects market expectations on three-month euroEuro deposits (euribor) into the future. The difference between futures contracts on the three-month cash eurodollar and on the euroEuro deposit is an essential variable in determining EUR/USD expectations.
Other Indicators: There is a strong negative correlation between EUR/USD and USD/CHF, reflecting a steadily similar relationship between the euro and the Swiss franc. This is because the Swiss economy is largely dependent upon the eurozone economies. In most cases, a spike (dip) in EUR/USD is accompanied by a dip (spike) in EUR/CHF. The inverse also usually holds. This relationship sometimes fails to hold in the event of data or factors pertaining solely to either of the currencies.
Political Factors: As with all exchange rates, EUR/USD is susceptible to political instability such as a threat to coalition governments in France, Germany or Italy. Political or financial instability in Russia is also a red flag for EUR/USD because of the substantial amount of German investment in Russia.
Bank of England (BoE): Under the Bank of England Act of June 1997, the BoE obtained operational independence in setting monetary policy to deliver price stability and to support the government’s growth and employment objectives. The price stability objective is set by the government's inflation target, defined as 2.5% annual growth in Retail Prices Index excluding mortgages (RPI-X). Hence, despite its independence in setting monetary policy, the BoE remains dependent on having to meet the inflation target set by the Treasury.
Monetary Policy Committee(MPC): The BoE's Committee responsible for making decisions on interest rates.
Interest Rates: The Central Bank's main interest rate is the minimum lending rate (base rate), which it uses to send clear signals on monetary policy changes in the first week of every month. Changes in the base rate usually have a large impact on sterling. The BoE also sets monetary policy through its daily market operations used to change the dealing rates at which it buys government bills from discount houses (specialized institutions in trading money market instruments).
Gilts: Government bonds known as gilt-edged securities. The spread differential (difference in yields) between the yield on the ten-year gilt and that on the ten-year US Treasury note usually impacts the exchange rate. The spread differential between gilts and German bunds is also important, as it impacts the EUR/GBP exchange rate, which could affect GBP/USD (see cross-rate effect).
Three-month Eurosterling Deposits: Eurodollar deposits are bank accounts deposited in a country other than the country of the currency; e.g. Japanese yen accounts deposited outside Japan are called "euroyen". Similarly, euro-denominated accounts deposited outside the eurozone are called "EuroEuros". The interest rate on three-month sterling-denominated deposits held in banks outside the UK. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Using a theoretical example on GBP/USD, the greater the interest rate differential in favor of the eurodollar against the eurosterling deposit, the more likely GBP/USD is to fall. Sometimes, this relation does not hold due to the confluence of other factors.
Treasury: The Treasury’s role in setting monetary policy diminished markedly since the Bank of England Act of June 1997. Nevertheless, the Treasury still sets the inflation target for the BoE and makes key appointments at the Central Bank.
Economic Data: The most important economic data items released in the UK are: The claimant unemployment (number of unemployed), claimant unemployment rate, average earnings, RPI-X, retail sales, supply (M4), balance of payments, and housing prices.
Three-month Eurosterling Futures Contract (short sterling): The contract reflects market expectations on three-month eurosterling into the future. The difference between futures contracts on the three-month eurodollar and eurosterling deposits is an essential variable in determining GBP/USD expectations.
FTSE-100: Britain's leading stock index. Unlike in the US or Japan, Britain’s main stock index has relatively less influence on the currency. Nevertheless, the positive correlation between the FTSE-100 and the Dow Jones Industrial Index is one of the strongest in the global markets.
Cross Rate Effect: GBP/USD is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/GBP. To illustrate: A rise in EUR/GBP (fall in sterling), triggered by strengthening expectations of UK 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 project will hurt the EUR/GBP, thereby boosting cable.
The exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. One of the most important factors is the status of a nation’s balance-of-payments position. 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 top price depreciation of a nation's currency relative to the prices of other currencies.
Inflation has a particularly potent effect on exchange rates, as do differences in real exchange rates between nations. When one nation’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 value of their currencies.
Overshadowing the currency market today is the ever-present possibility that central banks will become active participants. Major central banks around the world, including the Federal Reserve System in the United States and the Bundesbank in Germany, may decide on a given day that their national currency is declining too rapidly in value relative to other key currencies. Thus, if the dollar falls precipitously against the German mark, support operations by the Federal Reserve System in the form of heavy sales of marks and corresponding purchases of dollars may be employed to stabilize the currency markets. Usually, central bank intervention is temporary, designed to promote a smooth adjustment in currency values toward a new equilibrium level rather than to permanently prop up a weak currency.
Pairings of non-US dollar currencies 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 else it will be possible to “round trip” and make profits without risk.
Computing cross rates – an example
Assume that the following major exchange rates are known:
EUR/USD = 1.0060/65
GBP/USD = 1.5847/52
USD/JPY = 120.25/30
USD/CHF = 1.4554/59
To calculate GPB/CHF
GBP/USD: Bid: 1.5847 Offer: 1.5852
USD/CHF: 1.4554 1.4559
GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559
Going short – going long
When you buy a currency, you are said to be “long” in that currency. Long positions are entered into at the offer price. Thus, if you are buying one GBP/USD lot quoted at 1.5847/52, then you will buy 100,000 GBP at 1.5852 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 is 1.5847 USD in our example.
Because of the symmetry of 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 sterling and long in US dollars.
Closing out
An open position is one that is live and ongoing. As long as the position is open, its value will fluctuate in accordance with the exchange rate in the market. Any profits and losses will exist on paper only and will be reflected in your margin account.
To close out your position, you conduct an equal and opposite trade in the same currency pair. For example, if you have gone long in one lot of GBP/USD (at the prevailing offer price) you can close out that position by subsequently going short in one GBP/USD lot (at the prevailing bid price).
Your opening and closing trades must be conducted through the same intermediary. You cannot open a GBP/USD position with Broker A and close it out through Broker B.
Betting on a rise
Assume that you start with a clean slate and that the current GPB/USD rate is 1.5847/52.
- You expect the pound to appreciate against the US dollar, so you buy 100,000 GBP at the offer price of 1.5852 USD.
- The value of the contract is 100,000 X 1.5852 USD = 158, 520 USD.
- GBP/USD duly appreciates to 1.6000/05 and you decide to close out your position by selling your sterling for US dollars at the bid rate. Your gain is:
100,000 X (1.6000 – 1.5852) USD = 1,480 USD, the equivalent of 10 USD per point
- You earn 1,480 USD on an exchange rate movement of less than 1%. This illustrates the positive effect of buying on margin.
- Had GBP/USD fallen to 1.5700/75, your loss would have been:
100,000 X (1.5852 – 1.5700) USD = 1,520 USD
The lesson is that margin trading magnifies your rate of profit or loss.
You expect sterling to fall from GBP/USD = 1.5847/52 so you decide to sell 100,000 GBP/USD.
- The value of the contract is 100,000 X 1.5847 USD = 158,470 USD. You have effectively sold 100,000 GBP and bought 158,470 USD.
- If your broker requires 1% of 158,470 USD as margin in US dollars, namely 1,584.70 USD in cash GBP/USD falls to 1.5555/60 and you are looking at a paper gain of:
- 100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
- Your 2,870 USD paper gain is credited to your margin account where you now have 4,454.70 USD. This enables you to maintain open positions worth 4,454.70 USD.
- However, GBP/USD starts to rise. When it reaches 1.6000/05, you are looking at a paper loss of:
100,000 X (1.6005 – 1.5847) USD = 1,580 USD.
- Your margin account is debited by 1,580 USD, taking it down to 2,874.70 USD
Without the apparatus for making sense of the currency market, any trade represents a pure gamble. There are two broad schools of analysis, which are not mutually exclusive.
Fundamental analysis:
Fundamental analysis is the application of the micro and macroeconomic theory to markets, with the aim of predicting future trends. So what fundamental forces drive currency markets?
Balance of trade: Currencies that are associated with long-term trade surpluses will tend to strengthen against those associated with persistent deficits, simply because there is net buying of surplus currencies corresponding to the excess of exports over imports. Trends are important too. An improving balance of trade should cause the relevant currency to appreciate relative to those associated with a deteriorating or stable balance of trade.
Relative inflation rates: If country A is suffering a higher rate of price inflation than country B, then A’s currency ought to weaken relative to B’s in order to restore “purchasing power parity.”
Interest rates: International capital flows seek the highest inflation-adjusted returns, creating additional demand for high real interest-rate currencies and pushing up their rates of exchange.
Expectations and speculation: Markets anticipate events. Speculation on, say, the future rate of inflation may be enough to move the exchange rate, long before the actual trend becomes apparent.
It should be understood that these economic forces act in concert. It is a supremely difficult task, however, to establish where the sum of interacting economic forces will take the market. The solution, some argue, lies in technical analysis.
Technical analysis
Technical analysis is concerned with predicting future price trends from historical price and volume data. The underlying axiom of technical analysis is that all fundamentals (including expectations) are factored into the market and are reflected in exchange rates.
The tools of technical analysis are now freely available to private investors in support of their trading decisions. It cannot be overly stressed, however, that such tools are only estimators and are not infallible.
The following is the briefest of introductions to the technical analytical tools used to identify trends and recurring patterns in a volatile marketplace. Aspiring Forex dealers are advised to undergo proper training in technical analysis, although true proficiency comes with practice, endurance, and experience.
Charts
Line Chart: AA graphic depiction of the exchange rate history of any currency pair over time. The line is constructed by connecting up daily closing prices.
Bar chart: A depiction of the price performance of the currency pair, made up of vertical bars at set intra-day time intervals (e.g. every 30 minutes). Each bar has four “hooks,” representing the opening, closing, high and low (OCHL) exchange rates for that time interval.
Candlestick chart: AA variant of the bar chart except that it depicts OCHL prices as “candlesticks” with a wick at each end. Where the opening rate is higher than the closing rate the candlestick is “solid”. Where the closing rate exceeds the opening rate, the candlestick is “hollow.”
Support, resistance, channels, and triangles
Support and resistance thresholds are common features of all tradable financial commodities, including currencies. Breaches of such thresholds are taken as evidence of a fundamental change in market sentiment towards a currency.
Support and resistance often form coherent patterns over time in the shape of channels.
Support
A support level is detected if you can connect up several under-points of the exchange rate cycle on a straight line. This is taken to indicate market reluctance to sell below certain rates of exchange. The more under-points that can be connected, the more evidence there is of a support level.
The support level may change with the passage of time. If the straight line inclines upwards then we speak of “upward support.” Where the line is horizontal we identify “sideways support.” Where the line slopes downwards we diagnose “downward support.”
Resistance
Resistance levels indicate a reluctance to buy a currency above given exchange rates. A resistance level is detected if it is possible to connect a succession of upper points in the exchange rate cycle with a single straight line.
As you would expect, one encounters upward, sideways, and downward resistance.
Channels are identified by superimposing support and resistance levels on a single line chart. Channels can slope upward, sideways or downward.
Triangles
Where resistance and support lines converge towards one another over time, “triangles” are formed which can be upward, sideways or downward sloping.
Triangles indicate declining profitability over time. Resistance and support levels superimposed on a chart will help predict the time of convergence. What we are seeking are “breakouts” that could go in either direction and which are likely to be “explosive,” presenting opportunities for profitable trading.
The slope of the triangle and the behavior of the pricing cycle in the approach to the predicted intersection of resistance and support may indicate the likely direction of the breakout. For example, if the exchange rate cycle is in a clear upward phase, the breakout is likely to be upwards too. There are some real opportunities here, but also much risk.
Moving averages
Moving averages smooth out the peaks and troughs of the exchange rate cycle over a rolling period and indicate the presence of a trend.
There are two main types of moving averages:
Simple: Where past and present data are assumed to be of equal importance and are weighted equally.
Weighted: Where current data is considered more important than past data and is weighted more heavily. The weighting factor takes the form of a “smoothing constant” that increases exponentially over time.
If prices lie below two or more moving averages, this is taken as a bearish signal, and vice versa.
Stochastic oscillators
Stochastic oscillators are momentum indicators that purport to tell you when to buy or sell. They are composed of two elements:
- A “%K” line that measures the difference between the most recent closing price and the deepest trough as a percentage of the difference between the highest peak and the deepest trough, measured over a given period (e.g. 14 days).
- A “%D” line that tracks the three-period (e.g. day) moving average of %K.
When the oscillator touches 80, the currency is considered overbought. An oscillator below 20 is considered to indicate an oversold currency.