Trading Tutorial

Tutorial to Forex

FOREIGN EXCHANGE RATES DEFINED:

A foreign exchange rate is the relative value between two currencies. More specifically it is the required quantity of one currency to buy or sell one unit of another currency. This is also called a pairing; EUR/USD at 1.3250 means that one Euro can be exchanged for 1.3250 US dollars.
The pairing of currencies can also be reversed. In this case the rate expresses how much one US dollar is worth in a foreign currency. For example, USD/JPY at 103.00, means that one US dollar buys 103.00 Japanese Yens.
A cross rate is the expression of an exchange rate that does not involve the US dollar. The pairing EUR/JPY at 136.50 signifies that one Euro can be exchanged for 136.50 Japanese yens.

DIFFERENT FOREIGN EXCHANGE SYSTEMS:

Flexible Exchange Rate System:

In a flexible exchange rate system the monetary authority - the central bank - adjusts the exchange rate to affect the supply and demand for foreign currencies.

Fixed Exchange Rate System:

In a fixed exchange rate system, the currencies are not fluctuating, instead they are fixed to each other at a particular rate. This requires the central bank to have a large reserve of both the domestic and the foreign currency. Whenever there is a tendency for the market price of the foreign currency to increase, the central bank must sell that foreign currency in amounts that can prevent the price increase. Conversely, if the tendency of the foreign currency is down, the central bank will have to buy the foreign currency in quantities that will prevent the price drop. Therefore, in a fixed exchange rate system the central bank must be ready to buy and sell its domestic currency at a fixed price relative to the foreign currency.

AN OTC MARKET:

The Foreign Exchange Market, or "Forex" market, is the largest financial market in the world with an average daily turnover exceeding 2 trillion US dollars (2,000,000,000,000).
The Forex market is the arena where currencies are exchanged and traded. Investors around the world purchase or sell one currency for another in the hope of making a profit when the value of the currencies changes in response to market news and events or as a result of market speculation.
It is an 'over the counter market' (OTC), which means that there is no physical location and no central exchange and clearing hours where orders are matched. Instead it operates 24 hours a day through an electronic network of banks, corporations and individuals trading one currency for another.
FX traders constantly negotiate prices between one another and the resulting market bid/ask prices are then fed into computers and displayed on official quote screens. Forex exchange rates quoted between banks are referred to as Inter-bank Rates.

THE DIFFERENT PARTICIPANTS OF THE FOREX MARKET

In the following we have organized the different participants of the Forex market in a hierarchy:

  • The Inter-bank market accounts for the most significant portion of Forex volumes. In this market, the largest banks deal with each other directly via Inter-bank brokers or through electronic broking systems like Reuters. These banks both trade as a service to their customers and for their own benefits.
  • The Central Banks control their countries’ money supply and they act to affect or maintain financial stability.
  • International corporations are important players in the Forex market, as they exchange large amounts of currencies.
  • The many travelers who need to exchange their currencies to pay for goods and services when abroad.
  • Investors and speculators are becoming increasingly aware of the opportunities within the Forex market.

FOREIGN EXCHANGE SPREADS

Exchange rates in the Forex market are quoted as 'bid/ask' rates. The difference between the purchase (ask) and the sale (bid) rates is called the 'spread'. For example, GBP/USD = 1.8281/84 means that the bid price of GBP is 1.8281 USD and the ask price is 1.8284 USD. In this case the spread is 3 pips.
There may be great differences in the spread from one currency pair to the other, depending on whether it is a weak or a strong currency as well as its past and anticipated volatility.

Different ways to trade forex

  • The spot market
  • Forwards and Futures
  • Options
  • Spread betting

SPOT FOREX VERSUS CURRENCY FUTURES

There is a tendency for more and more traders to change from currency futures to spot Forex. There are several reasons for this. First, spot Forex provides better liquidity and in general lower trading costs than currency futures. In addition, banks and brokers in spot Forex give quotes 24 hours a day.  Moreover, the spot Forex is not incurred with exchange and NFA ("National Futures Association") fees, which are generally passed on to the customer in the form of high commissions. 
The mechanism of trading spot Forex is similar to trading currency futures. However, an important difference is the way currency pairs are quoted. Currency futures are always quoted as the currency versus the US dollar. For spot Forex some currencies are also quoted as the currency versus the US dollar, while others are quoted as the US dollar versus the currency. Forex EUR/USD is for instance quoted the same way as Euro futures. This means that if the Euro is strengthening relative to the US dollar, the EUR/USD will rise just as Euro futures will climb. 
However, in spot Forex the Japanese Yen is quoted as the US dollar versus the Japanese Yen, whereas the opposite is the case for Japanese Yen futures. Therefore, if the Japanese Yen strengthens relative to the US dollar, the spot USD/JPY will fall, while Japanese Yen futures will rise.
The rule in spot Forex is that the first currency is always the one being quoted in terms of direction.  For example, "EUR" in EUR/USD and "USD" in USD/JPY are the currencies being quoted. The table below shows the spot currencies that are moving parallel to the futures and the ones moving in the inverse direction:


Forex
Symbol

Currency Pair

Futures
Symbol

Directional
Relationship

GBPUSD

British Pound / US Dollar

BP

Parallel

EURUSD

Euro / US Dollar

EU

Parallel

USDJPY

US Dollar / Japanese Yen

JY

Inverse

USDCHF

US Dollar / Swiss Franc

SF

Inverse

USDCAD

US Dollar / Canadian Dollar

CD

Inverse

AUDUSD

Australian Dollar / US Dollar

AD

Parallel

NZDUSD

New Zealand Dollar / US Dollar

ND

Parallel

ADVANTAGES OF TRADING FOREX:

Forex trading is one of the most popular and fastest growing trading methods available. When it comes to active trading, it is hard to beat currencies and Forex.
In the following are listed some of the benefits of currency trading:

24 hour market

The Forex market is active 24 hours a day because of the overlap between the major markets in Europe, Asia, and the United States and in the dealing rooms dealers are working in three shifts. Clients have the possibility to place take-profit and stop-loss orders with brokers for overnight execution. The Forex market opens Sunday 23:00 CET through Friday 23:00 CET, which gives traders the opportunity to react immediately to market news and hereby determine their own trading hours.

Liquidity

Forex trading has become increasingly popular over the past thirty years. With an average daily volume of $ 1.5 trillion, Forex is 46 times larger than all the futures markets combined, which makes it the world's most liquid market.
In the past, Forex trading was largely limited to huge money central banks and other institutional traders. But over the past few years, technological innovations and the development of online trading platforms, has also made it possible for small traders to take advantage of the significant benefits of trading Forex.

Leverage

Margin ratios associated with trading currencies are typically higher than those associated with trading equities. This is primarily due to the higher levels of liquidity within the currency market. Margin trading allows FX market participants to trade much larger amounts than they have deposited. For example, with a margin ratio of 20:1 and a deposit of 10,000 USD, an investor can trade amounts of up to 200,000 USD. Trading in large volumes allows investors to take advantage of even small price movements.

Low spreads

Currency trading offers spreads that are much lower than the ones in the equities market (especially in after-hour markets). Historically, tight currency spreads of 2 pips have only been available for transaction sizes of 1 million USD or higher, but today these tighter spreads are also available for investors trading smaller transaction sizes.

No commissions or transaction costs

A currency transaction typically incurs no commission or transaction fee besides the quoted spread. This is in stark contrast to the equity market, where commissions for stock trades range from 8 to 70 USD or even higher, in addition to the quoted spread.

Profit potential regardless of market direction

An investor with an open position is by definition long one currency and short another. If a trader believes a currency is about to depreciate, he/she sells that currency short and goes long another currency. In the currency markets, selling or shorting is a necessary component of completing a trade. Profit potential exists in the FX market regardless of whether a trader is buying or selling and regardless of whether the market is moving up or down. In the US equity markets, short-selling is less common and more difficult to transact due to different regulations and market rules. This makes it more difficult to make a profit when the stock market and/or the share price for a particular stock is going down.

Equal access to market information

Professional traders and analysts in the equity market have an important competitive advantage in comparison with the individual trader as they have access to important corporate information, such as earning estimates and press releases, before it is released to the general public. This is in stark contrast to the Forex market, where pertinent information is equally accessible to everybody, ensuring that all market participants can take advantage of market moving news as soon as it becomes available.

No Restrictions

No restrictions apply to the Forex market and there are very low account balances. This means that traders can enjoy profit opportunities in all market conditions.

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