An Introduction to FOREX

An Introduction to FOREX

What is FOREX ?

FOREX is an informal network of trading relationships between the world's major banks and other market participants, sometimes referred to as the interbank market. The foreign exchange market has no central clearinghouse or exchange, and is considered an over-the-counter (OTC) market.

The foreign exchange market is the largest financial market in the world. Approximately 1.9 trillion dollars are traded daily in the foreign exchange market, which means it dwarves the stock market of any country. The FOREX Market’s volume is 24 times bigger than the accumulated Futures Markets.

Because currencies are traded in markets in various countries, currencies can be traded 24 hours, six days a week. The bulk of currency trading takes place in London, with New York coming second and Hong Kong, Japan and Singapore seeing the bulk of currency trading during Asian business hours. The only time when currencies are not trading is after Japan closes for business on Friday, there is a one day window before Europe is open for business.

Currency markets are also one of the most volatile markets. One of the reasons for this is the sheer size of the market, and its sensitivity to so many variables. Whereas a company trading on the stock market is susceptible to its own news and the health of the economy where it does business, there are many more variables that can affect currencies. International politics, enthusiasm for one currency that causes another to weaken even though there's no apparent reason for it, weather, and war — there is a virtually endless list.

Forex Market Summary of Benefits Forex is open 24 hours a day Forex is the most liquid market in the world Leverage reduces the need for large amounts of capital No restrictions on shorting which allows you to profit from opportunities during any market condition Standard instrument for controlling risk exposure.

A brief look on FOREX’s History

1944 Bretton Woods Accord implemented to stabilize currency rates and help sustain world economic recovery in wake of World War II. USD becomes benchmark currency.

1971 Smithsonian Agreement supercedes Bretton Woods Accord, allowing greater fluctuations in currencies

1973 Smithsonian Agreement fails and sparks the dawn of the age of the Free-Float system

1978 The European Monetary System is created in renewed bid to gain independence for European currencies from the U.S. dollar.

1979Associated Foreign Exchange, Inc. is incorporated with the mission of helping businesses, organizations and individuals who need to transact business in an increasingly complicated forex market.

1993 European Monetary System fails, signaling the final evolution to a worldwide free Float foreign exchange system.

1999 European legacy currencies (French franc, German mark, etc.) cease trading as euro becomes the single Eurozone currency.

In 1967, a Chicago bank refused a college professor by the name of Milton Friedman a loan in pound sterling because he had intended to use the funds to short the British currency. Friedman, who had perceived sterling to be priced too high against the dollar, wanted to sell the currency, then later buy it back to repay the bank after the currency declined, thus pocketing a quick profit. The bank’s refusal to grant the loan was due to the Bretton Woods Agreement, established twenty years earlier, which fixed national currencies against the dollar, and set the dollar at a rate of $35 per ounce of gold.

The Bretton Woods Agreement, set up in 1944, aimed at installing international monetary stability by preventing money from fleeing across nations, and restricting speculation in the world currencies. Prior to the Agreement, the gold exchange standard--prevailing between 1876 and World War I--dominated the international economic system. Under the gold exchange, currencies gained a new phase of stability as they were backed by the price of gold. It abolished the age-old practice used by kings and rulers of arbitrarily debasing money and triggering inflation.

But the gold exchange standard didn’t lack faults. As an economy strengthened, it would import heavily from abroad until it ran down its gold reserves required to back its money; consequently, the money supply would shrink, interest rates rose and economic activity slowed to the extent of recession. Ultimately, prices of goods had hit bottom, appearing attractive to other nations, who would rush into buying sprees that injected the economy with gold until it increased its money supply, and drive down interest rates and recreate wealth into the economy. Such boom-bust patterns prevailed throughout the gold standard until the outbreak of World War I interrupted trade flows and the free movement of gold.

After the Wars, the Bretton Woods Agreement was founded, where participating countries agreed to try and maintain the value of their currency with a narrow margin against the dollar and a corresponding rate of gold as needed. Countries were prohibited from devaluing their currencies to their trade advantage and were only allowed to do so for devaluations of less than 10%. Into the 1950s, the ever-expanding volume of international trade led to massive movements of capital generated by post-war construction. That destabilized foreign exchange rates as setup in Bretton Woods.

The Agreement was finally abandoned in 1971, and the US dollar would no longer be convertible into gold. By 1973, currencies of major industrialized nations floated more freely, as they were controlled mainly by the forces of supply and demand. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s, giving rise to new financial instruments, market deregulation and trade liberalization.

In the 1980s, cross-border capital movements accelerated with the advent of computers and technology, extending market continuum through Asian, European and American time zones. Transactions in foreign exchange rocketed from about $70 billion a day in the 1980s, to more than $1.5 trillion a day two decades later.

Facts & Figures

Cross Rates

Forward Premium/Discount Point

FOREX Correlation Table (5 days)

      EUR-USD  

USD-JPY    

GBP-USD  

USD-CHF    

USD-CAD  

AUD-USD  

EUR-JPY    

EUR-CHF    

USD-NOK  

GBP-JPY    

EUR-USD - 25- 85+ 95- 06- 51+ 21+ 47- 77- 47+

USD-JPY 25- - 17+ 01+ 79- 90- 90+ 59- 03- 71+

GBP-USD 85+ 17+ - 95- 21- 21+ 55+ 83- 96- 82+

USD-CHF 95- 01+ 95- - 23+ 31- 43- 72+ 87+ 68-

USD-CAD 06- 79- 21- 23+ - 81+ 83- 55+ 01- 62-

AUD-USD 51+ 90- 21+ 31- 81+ - 68- 29+ 35- 38-

EUR-JPY 21+ 90+ 55+ 43- 83- 68- - 81- 38- 92+

EUR-CHF 47- 59- 83- 72+ 55+ 29+ 81- - 78+ 94-

GBP-JPY 47+ 71+ 82+ 68- 62- 38- 92+ 94- 71- -

CHF-JPY 26+ 87+ 61+ 49- 81- 64- - 86- 45- 95+

EUR-GBP 68- 35- 96- 84+ 26+ 05- 66- 91+ 95+ 90-

NZD-USD 44+ 73+ 68+ 64- 86- 53- 94+ 86- 49- 92+

EUR-NZD 16- 89- 47- 39+ 92+ 75+ 97- 80+ 29+ 86-

AUD-JPY 38+ 65+ 76+ 56- 38- 26- 82+ 80- 69- 93+

EUR-AUD 03+ 89+ 28+ 24- 98- 84- 91+ 63- 07- 72+

EUR-CAD 57+ 81- 35+ 40- 79+ 98+ 56- 16+ 49- 22-

GBP-CHF 71+ 29+ 97+ 85- 18- 13+ 61+ 86- 96- 86+

FOREX Correlation Table (20 days)

      EUR-USD  

USD-JPY    

GBP-USD  

USD-CHF    

USD-CAD  

AUD-USD  

EUR-JPY    

EUR-CHF    

USD-NOK  

GBP-JPY    

EUR-USD - 28- 41+ 96- 29- 39+ 43+ 40- 05- 06+

USD-JPY 28- - 35+ 13+ 63- 33- 74+ 34- 32+ 84+

GBP-USD 41+ 35+ - 54- 56- 53+ 62+ 65- 08+ 80+

USD-CHF 96- 13+ 54- - 35+ 34- 55- 63+ 10+ 23-

USD-CAD 29- 63- 56- 35+ - 24- 79- 33+ 60- 72-

AUD-USD 39+ 33- 53+ 34- 24- - 04- 05- 29+ 09+

EUR-JPY 43+ 74+ 62+ 55- 79- 04- - 60- 26+ 83+

EUR-CHF 40- 34- 65- 63+ 33+ 05- 60- - 22+ 59-

GBP-JPY 06+ 84+ 80+ 23- 72- 09+ 83+ 59- 25+ -

CHF-JPY 46+ 71+ 66+ 61- 75- 03- 99+ 72- 18+ 84+

EUR-GBP 43+ 58- 65- 26- 31+ 21- 25- 32+ 12- 74-

NZD-USD 61+ 31+ 69+ 65- 75- 52+ 73+ 41- 50+ 60+

EUR-NZD 39- 46- 67- 44+ 78+ 48- 71- 34+ 60- 69-

AUD-JPY 14+ 48+ 78+ 21- 72- 66+ 55+ 32- 52+ 76+

EUR-AUD 25+ 16+ 30- 27- 06+ 79- 32+ 20- 34- 07-

EUR-CAD 20+ 78- 37- 11- 88+ 06- 60- 15+ 63- 71-

GBP-CHF 57- 50+ 49+ 47+ 22- 21+ 07+ 02- 19+ 60+

FOREX Correlation Table (100 days)

      EUR-USD      

USD-JPY      

GBP-USD      

USD-CHF      

USD-CAD      

AUD-USD      

EUR-JPY      

EUR-CHF      

USD-NOK      

GBP-JPY      

EUR-USD - 33- 88+ 83- 45- 56+ 25+ 05+ 44- 39+

USD-JPY 33- - 11- 68+ 45+ 24- 84+ 72+ 87+ 69+

GBP-USD 88+ 11- - 65- 35- 64+ 40+ 19+ 23- 65+

USD-CHF 83- 68+ 65- - 54+ 33- 21+ 52+ 74+ 05+

USD-CAD 45- 45+ 35- 54+ - 20- 20+ 29+ 37+ 09+

AUD-USD 56+ 24- 64+ 33- 20- - 08+ 27+ 25- 28+

EUR-JPY 25+ 84+ 40+ 21+ 20+ 08+ - 77+ 63+ 93+

EUR-CHF 05+ 72+ 19+ 52+ 29+ 27+ 77+ - 64+ 70+

GBP-JPY 39+ 69+ 65+ 05+ 09+ 28+ 93+ 70+ 50+ -

CHF-JPY 30+ 75+ 43+ 03+ 12+ 04- 95+ 52+ 52+ 89+

EUR-GBP 51- 15- 86- 28+ 15+ 55- 45- 28- 06- 74-

NZD-USD 29+ 02+ 47+ 06- 39- 64+ 19+ 34+ 05+ 36+

EUR-NZD 22+ 18- 03- 36- 16+ 36- 06- 31- 27- 16-

AUD-JPY 14+ 68+ 40+ 34+ 23+ 54+ 78+ 83+ 56+ 81+

EUR-AUD 12+ 01- 07- 28- 17- 72- 06+ 32- 08- 06-

EUR-CAD 52+ 11+ 50+ 27- 53+ 34+ 42+ 32+ 07- 45+

GBP-CHF 39+ 48+ 72+ 06+ 04+ 54+ 72+ 72+ 37+ 90+

Forex Arbitrage

Forex Arbitrage is an arbitrage among real rates and synthetic cross rates in different local markets.

For example, suppose a trader has accounts with forex brokers in New York, Tokyo, and London. As far as local quotes are determined by local players, there are sometimes arbitrage opportunities among different locations. In our case the real rates are gbp/usd 1.6388 1.6393 (NY), eur/usd 1.1832 1.1837 (Tokyo), and the cross rate eur/gbp is 0.7231 0.7236 (London)

In such situation exists risk-free arbitrage opportunity with estimated profit equal to $13.1 on a mini contract. Indeed buying 100,000 EUR for $118,370 (10 mini lots or a one standard lot), and selling 100,000 EUR for 72,310 GBP, and selling 72,310 GBP for $118,501 gives zero exposures in EUR and GBP with profit of $131.

Such arbitrage is possible if the trader's positions are netting (clearing) by some "clearing house". A one possible way to realize this strategy is to find three brokers having the same clearing firm. Then you should make agreement with this clearing firm on "netting" services. It means that clearing firm will clear (net) your positions across three pairs at specified time using the opening rates. For example, in the example above suppose you had opened the following positions long 100,000 EUR/USD; short 100,000 EUR/GBP; and short 72,310 GBP/USD at 10:00AM and instructed the clearing firm to clear these position at 16:00 PM at the opening rates. The netting/clearing gives the following results: Long EUR from the first pair and short EUR from the second pair gives zero exposure in EUR. Long position in GDP from the second pair and short position from the third pair gives zero exposure in GBP. Short position from the first pair ($118,370) in USD and long position from the third pair ($118,501) in USD gives you $131 profit without open positions and exposures.

The second possible way is to use some agreements (options or swap) to guaranty clearing/netting at these specific rates, which give risk-free arbitrage profit.

FOREX Trading

Even though the mighty US dominates many markets, most of Spot Forex is still traded through London in Great Britain. So for our next description we shall use London time. Most deals in Forex are done as Spot deals. Spot deals are nearly always due for settlement two business days later. This is referred to as the value date or delivery date. On that date the counter parties theoretically take delivery of the currency they have sold or bought.

In Spot FX the majority of the time the end of the business day is 21:59 (London time). Any positions still open at this time are automatically rolled over to the next business day, which again finishes at 21:59.

This is necessary to avoid the actual delivery of the currency. As Spot FX is predominantly speculative most of the time the traders never wish to actually take delivery of the currency. They will instruct the brokerage to always rollover their position.

Many of the brokers nowadays do this automatically and it will be in their policies and procedures. The act of rolling the currency pair over is known as tom.next, which stands for tomorrow and the next day.

Just to go over this again, your broker will automatically rollover your position unless you instruct him that you actually want delivery of the currency. Another point noting is that most leveraged accounts are unable to actually deliver the currency as there is insufficient capital there to cover the transaction.

Remember that if you are trading on margin, you have in effect got a loan from your broker for the amount you are trading. If you had a 1 lot position you broker has advanced you the $100,000 even though you did not actually have $100,000. The broker will normally charge you the interest differential between the two currencies if you rollover your position. This normally only happens if you have rolled over the position and not if you open and close the position within the same business day.

To calculate the broker's interest he will normally close your position at the end of the business day and again reopen a new position almost simultaneously. You open a 1 lot ($100,000) EUR/USD position on Monday 15th at 11:00 at an exchange rate of 0.9950.

During the day the rate fluctuates and at 22:00 the rate is 0.9975. The broker closes your position and reopens a new position with a different value date. The new position was opened at 0.9976 - a 1 pip difference. The 1 pip deference reflects the difference in interest rates between the US Dollar and the Euro.

In our example your are long Euro and short US Dollar. As the US Dollar in the example has a higher interest rate than the Euro you pay the premium of 1 pip.

If you had the reverse position and you were short Euros and long US Dollars you would gain the interest differential of 1 pip. If the first named currency has an overnight interest rate lower than the second currency then you will pay that interest differential if you bought that currency. If the first named currency has a higher interest rate than the second currency then you will gain the interest differential.

To simplify the above. If you are long (bought) a particular currency and that currency has a higher overnight interest rate you will gain. If you are short (sold) the currency with a higher overnight interest rate then you will lose the difference.

Common Order TypesMarket OrderAn order to buy or sell at the current market price.Limit OrderAn order to buy or sell at a specified level.Stop-Loss OrderAn order to restrict losses at a specified level.Limit Entry Order An order to buy below the market or sell above the market at a specified level, believing that the price will reverse direction from that point. Stop-Entry Order An order to buy above the market or sell below the market at a specified level, believing that the price will continue in the same direction.

Trading StylesScalping A style of trading that involves frequent trading seeking small gains over a very period of time. Trades can last from seconds to minutes. Day Trading A style of trading that involves multiple trades on an intra-day basis. Trades can last from minutes to hours. Swing Trading A style of trading that involves seeking to profit from short to medium term swings in trend. Trades can last from hours to days. Position Trading A style of trading that involves taking a longer term position that reflects a longer term outlook. Trades can last from weeks to months. Discretionary Trading A style of trading that involves the human decision making process for every trade. Automated Trading A style of trading that involves neither human decision making or involvement, whereby a pre-programmed trading strategy is automatically executed by computer software.

Calculating the position size for a EUR/GBP trade

Equity: USD 150.000,00Lot Size: 100.000Leverage: 100:1

Entry: 0,6781 Break of Exponential Moving Average (Period 30) Exit: 0,6721 21 day Break Out Risk on equity/trade: 1% = USD 1.500,00

1) Calculating the PIP differential:PIP differential = Entry Price – Exit Price

PIP differential = 0,6781 – 0,6721 = 0,0060 = 60 Pips

2) Calculating Cross Rate Pip ValuePip stands for "price interest point" and refers to the smallest incremental price move of a currency. Tick size is the smallest possible change in price. The base quote is the current base pair quote. Pip value for cross rates are calculated according to the following formula:

Pip = lot size * tick size * base quote / current rate

Pip = 100.000 * 0,0001 * 1,2790 (EUR/USD) / 0,6790 (EUR/GBP) = USD 18,83

3) Calculating the Position Size:Position Size = risk/trade USD / (pip differential * pip size)

Position Size = 1.500,00 / (60 * 18,83) = 1,33 (therefore 1 contract can be traded)

4) Calculating the Margin required:Margin = Lot Size * Spot Price * Leverage % * Position Size

Leverage = 100:1 = 1% of equity

Margin = 100.000 * 1,2790 (Spot price of EUR/USD) * 1% * 1 contract = USD 1.279,005) Calculating the effective Leverage:

Leverage = Total value of units * Spot Price / Equity

Leverage = 100.000 * 1,2790 / 150.000 = 0,8526

Leverage = 85,26 : 1

Calculating the position size for a GBP/CHF tradeIn consideration of the Average True Range

Equity: USD 50.000,00Lot Size: 10.000Leverage: 200:1

Entry: 2,2847 Break of upper Bollinger Band (Period = 30, Deviation +/- 2)Exit: 2,2683 Break of Bollinger Bands MAV Risk/trade on equity: 1% = USD 500,00Average True Range (Period = 30): 0,0104Average True Range Factor = 2

1) Calculating the PIP differentialPIP differential = Entry Price – Exit Price

PIP differential = 2,2847 – 2,2683 = 0,0164 = 164 PIPs2) Calculating the Cross Rate PIP Value

PIP = lot size * tick size * base quote / current rate

PIP = 10.000 * 0,0001 * 1,5650 / 2,2850 = USD 0,693) Calculating the Position Size:

Position Size for Bollinger Band Stop = risk/trade USD / (pip differential * pip size)Position Size for Bollinger Band Stop = 500 / (164 * 0,69) = 4,42

Position Size for ATR = risk/trade USD / (ATR * ATR factor * pip sizePosition Size for ATR = 500 / (104 * 2 * 0,69) = 3,48

The lower contract size of each outcome is used. Therefore the trade will be initiated with 3 contracts, based on the ATR rule.

4) Calculating the Margin required:Margin = Lot Size * Spot Price * Leverage % * Position Size

Leverage = 200:1 = 0,5% of equity

Margin = 10.000 * 1,5650 * 0,5% * 3 = USD 234,755) Calculating the effective Leverage:

Leverage = Total value of units * Spot Price / Equity

Leverage = 30.000 * 1,5650 / 50.000 = 0,939

Leverage = 93,9 : 1

Trading PlatformsFX Solution – Global Trading System (www.fxsolutions.com)Trading Overview

Pending Orders

Open Orders

Current Currency Prices/Order Integration Open Position Summary Account Information

Order Routing

Open Position SummaryAccount Information

FXCM Trading Station (www.fxcm.com)

Saxo Trader 2 (www.saxobank.com)

VT Trader (www.vtsystems.com)

Important TermsSpot MarketThe market for buying and selling currencies at the current market rate.RolloverA spot transaction is generally due for settlement within two business days (the value date). If you open a position on Monday, the value date will be Wednesday, but if you hold it past rollover on Monday, the new value date will be Thursday. Every margin transaction involves borrowing one currency to purchase another, so you will pay interest on the currency borrowed, and earn it on the one purchased. For example, if you are long (bought) NZD and short (sold) JPY, you would earn interest on the NZD and pay it on the JPY. The amount you pay or receive is based on the interest rate differential between the two currencies in the transaction. Most brokers will automatically roll over your open positions (typically at 5PM New York time/10PM GMT) allowing you to hold a position for an indefinite period of time. Exchange RateThe value of one currency expressed in terms of another. For example, if EUR/USD is 1.3200, 1 Euro is worth US$1.3200.Currency PairThe two currencies that make up an exchange rate. When one is bought, the other is sold, and vice versa.Base CurrencyThe first currency in the pair. Also the currency your account is denominated in.Counter CurrencyThe second currency in the pair. Also known as the terms currency.ISO Currency CodesUSD = US DollarEUR = EuroJPY = Japanese YenGBP = British PoundCHF = Swiss FrancCAD = Canadian DollarAUD = Australian DollarNZD = New Zealand DollarCurrency Pair TerminologyEUR/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"The following pairs may sometimes be referred to by the following nicknames:EUR/USD = "Fiber"USD/JPY = "Gopher"EUR/GBP = "Chunnel"GBP/CHF = "Geppy"

Market MakerA market maker provides liquidity for a particular financial instrument and stands ready to buy or sell that instrument by displaying a two-way price quote. Market makers take the opposite side of your trade and earn their commission from the spread.ECNElectronic Communication Network. An ECN brings together multiple market makers and traders to trade together, matching buyer and seller together for a small fee. An ECN displays all the bids and offers available from all market makers and traders on the platform, and routes your order to the best available price. CounterpartyOne of the participants in a transaction.Sell QuoteThe 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 bid price. For example, if the EUR/USD quotes 1.3200/03, you can sell 1 Euro for US$1.3200.Buy QuoteThe 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 ask or offer price. For example, if the EUR/USD quotes 1.3200/03, you can buy 1 Euro for US$1.3203.Pip (Price Interest Point)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.Pip ValueThe value of a pip. To calculate pip value, divide 1 pip by the exchange rate and then multiply it by the number of units traded. For example, to calculate the pip value for USD/CHF, divide 1 pip (0.0001) by the current exchange rate (1.2765) and multiply it by the number of units traded (100,000) to get a pip value of $7.83. For EUR/USD, divide 1 pip (0.0001) by the current exchange rate (1.2075) and multiply it by the number of units traded (100,000) to get a pip value of €8.28. To convert it back to US dollars, multiply it by the exchange rate (1.2075) to get a pip value of $10.LotThe 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" lot, or 1,000 units if it's a "micro" lot. Some brokers offer no fixed lot size and can trade in any unit size.SpreadThe 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.Standard AccountTrading with standard lot sizesMini AccountTrading with mini lot sizes

MarginThe deposit required to open or maintain a position. A 1% margin requirement allows you to control a $100,000 position with $1,000 margin.

LeverageThe extent to which you are using borrowed funds. To calculate leverage, divide total open positions by account equity to get the leverage ratio. e.g. If a trader has $1,000 in his account and he opens a $100,000 position, he is trading with 100:1 leverage. If he opens a $200,000 position with $1,000 in his account, he is trading with 200:1 leverage.Manual ExecutionAn order which is executed by dealer intervention.Automatic ExecutionThe order is executed by computer software without human intervention or involvement.SlippageThe difference between the order price and the executed price.Long PositionA position in which the trader profits from an increase in price. Buy low, sell high.Short PositionA position in which the trader profits from a decrease in price. Sell high, buy low.DrawdownThe extent to which equity is lost in a trading account, measured in percentage terms.