Monday, 20 February 2017

Lesson 1 - Introduction to Forex Trading - Understanding the basics - Part 2

What is a currency pair?

As mentioned, Forex trading is the simultaneous act of buying of one currency and selling another. Currencies are traded through a broker or dealer, and are always traded in pairs; for example the euro and the US dollar (EUR/USD) or the British pound and the Japanese yen (GBP/JPY).
You will quickly get used to this format. This is not a real currency pair, but taking our sticks and stones example, the pair would look something like this: (STK/STN).

When you trade in the Forex market, you always buy or sell in currency pairs.

Major Currencies

The currencies included in the chart below are called the "majors", because they are the most widely traded ones.

majot currency pairs

Currency symbols without fail have three letters (having said that there are derivatives of these ie or EURUSD.fix which brokers use to distinguish the pair and relate it to an account type, in these examples a spread bet account or fixed spread account).

Traditionally, the first two letters identify the name of the country and the third letter identifies the name of that country's currency. (The exception to this is the euro, which had to be awkward and have a group of countries. This is simply written as EUR.)

Take GBP for instance. GB stands for Great Britain, while P stands for pound, so the symbol for the Great British pound is GBP.

Two of these symbols are then combined to indicate the currency that is being bought and the currency that is being sold.

For example, buying GBP/USD indicates that Great British pounds are being bought, while United States dollars are being sold.

Likewise, selling EUR/GBP indicates that euros are being sold, while Great British pounds are being bought.

Base vs Counter Currency

Now that it is clear that Forex is quoted in pairs of currencies, it is possible to explore the implementation of this further. In the example of EUR/USD, the value of one euro is being expressed in terms of US dollars, or how many dollars one euro costs.

Here’s a tip: it may help to consider the euro as the ‘product’ and the dollars as the ‘money’. Because the euro is the product, it is called the ‘base’ currency.

The ‘counter’ currency is simply the currency that the base currency is measured against – in this example, the US dollar. Therefore, if 10,000 units of EUR/USD are bought, 10,000 euros are being bought, while an equivalent amount of dollars (denoted by the EUR/USD exchange rate) are being sold.

To use a simple EUR/USD example:
First assume that the EUR/USD rate is 1.0616

Since one unit of the ‘base’ currency is equal to X units of the ‘counter’ currency, this is indicating that one unit of EUR is equal to 1.0616 units of USD. Therefore, if you buy 10,000 euros, you are in actual fact selling 10,616 US dollars (10,000 x 1.0616).

Don’t let the notional size of the trades in the example put you off. As each currency is measured in really small units, you need to use big trade sizes to get any meaningful results. This is where leverage and pips come into play.


A pip refers to the unit of measurement used to express the change in value between two currencies. “PIP", or, “pip” stands for Percentage in Point.

Note that different currency pairs are quoted to a different amount of decimal places, so if you refer to a pip, be clear as to which currency you mean.

If EUR/USD moves from 1.2250 to 1.2251, that .0001 USD change in value is equal to one pip. It is 1% of 1%. Many brokers these days quote prices to five decimal places. This is 0.1% of 1% and is eloquently referred to as a “pipette” or point.

Some currency pairs are quoted as three (previously two) decimal places of accuracy rather than five, as in EUR/USD. Pairs containing the Japanese yen are a typical example. The long-term average for JPY against the dollar is over one hundred, so if this was quoted to five decimal places not only would it involve an eight-digit number, but the value of a pip would be negligible.

In cases such as this, a change in USD/JPY from 99.000 to 99.010 is a change in price of one pip.
It is key to understand what a pip is in order to work out trade profits and losses (PnL).

If you trade using a spread betting firm, then chances are you are fixing the value of a pip to something like £1 per pip or £10 per pip. This means every 1-pip change you trade makes or loses £1 or £10.

If you are trading spot, then actually the value of a pip will change depending on the currency your account is denominated in and the currency pair you are trading.

Ideally you would know how to calculate this, but the reality is that your broker will provide you with the exact value of a pip. What you need to understand is that the pip value varies based on the exchange rates of the currency pairs, and so not all pips are equal. This means that when trading several different currency pairs in spot Forex consistently using the same size trades, not all trades will be worth the same amount.

For example, 10,000 notional on EURUSD and 10,000 notional on EURGBP from a UK account denominated in GBP could be worth very different amounts.

Why Trade Forex?

There are many benefits to trading Forex, as well as advantages of trading Forex over other asset markets. As technology has improved over the years, the methods and options to trade Forex have grown significantly.

The key driver for most people trading Forex, however, is the leverage available.

Essentially, in order to trade Forex you need to either have a lot of money or use broker leverage (or both!). Leverage is basically a way of trading a larger amount of capital than you have.

Consider that the average daily trading range on the EURUSD is around 100 pips. Most UK brokers offer about 100:1 leverage although this can be as high as 500:1). This means that for every £1 in an account, they will allow trades up to a nominal amount of £100 pounds.
If you fund your account with £10, then your maximum stake per pip is 10 pence. This is because the smallest trade it is possible to place is 1,000 units, more commonly referred to as 1 micro lot (a spread betting firm will have this as £0.1 per pip).

If you bet your £10 and manage to capture 100 pips in a day on our micro lot, you could make 100 * 10p = £10. In theory, 100% return in a day. Obviously, the counter is true and you could lose that money, but leverage allows people with smaller sums to take a bit more risk and make a lot more money.

This is why leverage is the key reason for trading in the Forex market. Leverage enables the little guys to make some real money that could make a difference.

Beyond leverage, here are some other key reasons people choose to trade Forex:

  • Markets are open 24 hours a day, 5 days a week, meaning you can trade in and around your job or other commitments.
  • There are typically low costs and very few requirements to start trading.
  • The market is big enough that someone can’t really corner it or force it in their direction. This means that in theory, the little guy has as much chance to make money as the big guys.
  • The information is ‘perfect’, meaning it is available to everyone simultaneously, so nobody is at a disadvantage.

There are lots of resources and tools out there to help you. You can even trade on demo accounts until you are ready.

And most importantly: because it’s extremely interesting being involved in markets, how they work and how they are affected by every day events. You will learn a lot about yourself and the world as you learn to trade.

Now that you are starting to see the value of trading in the market, it’s time to get to know your opponents.

Market Players

Until the late 1990s, only the "big guys" could play this game. The initial requirement was that you could trade only if you had significant funds (meaning millions) in the bank. Forex trading was traditionally intended to be for banks and large institutions, and not "little guys". However, because of the rise of the Internet, online Forex trading firms are now able to offer trading accounts to "retail" traders.

So let’s take a look at the mix, starting with retail traders/speculators.

Retail Traders / Speculators

Although the smallest part of the market in terms of individual trade size, speculators make up 90% of all trading volume. They engage in the Forex market for no other reason than to make money through buying and selling currencies. This category includes everyone from hedge funds through to the retail trader at home trading a £100 account.

The statistics show that retail traders are only about 30% accurate at picking the trend of the market. You might assume that hedge funds etc. would be better, but in fact a lot of hedge funds focus on making low probability, very high reward trades, i.e. long shots. This means they can actually be wrong a lot of the time, but if they get it right, they win very big. You may recall a few of the financial crash stories brought about by this type of activity.

Retail traders remain a growing market and will have an increasingly bigger impact in coming years. What’s likely, however, is that they will continue their losing ways on average, so make sure you are in the 30% that get it right!

So, who are the other big players you need to worry about?

Financial Institutions (Mainly Banks)

The largest of the players in the Forex market are the banks. Since the Forex spot market (note: ‘spot’ market refers to the buying and selling of currencies for cash right now on the spot, as opposed to any longer term bets through ‘futures’ or ‘forward contracts’) does not have a central exchange, the largest banks in the world are left to determine the exchange rates by trading with each other.

The prices they trade at provide the market with the bid and ask levels (as a retail trader, you buy at the ask price and sell at the bid price).

These prices are normally based on the supply and demand for currencies that they themselves are seeing through their customers. Bid is essentially the price a large financial institution is willing to buy the currency at, and therefore the price you can sell it at.

The ask price is the price the large financial institution is willing to sell the currency at, and therefore it is the price you buy it at.
The reason that the bid and ask is reversed for the bank and the customer is because the bank is the ‘Market Maker’ and the customer is the ‘Market Taker’. The bank is obliged to quote a price, regardless of whether they want the trade or not. Their reward for this is the difference in the price between the bid and the ask, otherwise known as the ‘Spread’.

These large banks, collectively referred to as the interbank market, take on a large amount of Forex transactions each day for both their customers and themselves.

The real thing you need to know about the banks is that they are the few people that have a full picture of order books. They can often tell where moves will happen before they do. That said, banks also make money on commissions, so if they can make more money through commissions on a losing trade, then they will. However, in the long run, you want to be on the side of the banks. This is why the COT report is so powerful; it allows you to follow bank positions (more on this later).

Governments and Central Banks

Governments, through their central banks, are regularly involved in the Forex market. Just like companies, national governments participate in the Forex market for their operations, including international trade payments and handling their foreign exchange reserves.

Meanwhile, central banks directly affect the Forex market when they adjust interest rates to control inflation or stimulate growth. By doing this, they can affect currency valuation. All else being equal (which it seldom is), global money moves to the currency with the highest interest rate, thus driving up the price for that currency.

There are also instances when central banks intervene in the Forex market, either directly or verbally, when they want to realign exchange rates. Sometimes, central banks think that their currency is priced too high or too low, so they start massive sell/buy operations to alter exchange rates.

There has also been a lot of verbal intervention over the years, often referred to as forward guidance or rhetoric. It is important to keep an eye on this as it can often set the overall tone and therefore longer-term trends for a currency.

Large Commercial Companies

Finally, we have the players the market was originally designed and built for.

Large commercial companies take part in the foreign exchange market for the purpose of doing business. For example, major airlines are often required to buy fuel for their planes in a number of different countries, or car manufacturers need to buy car parts from all over the world, so they use the Forex market to get the best deal on their currency needs.

The key here is that the majority of these companies use the Forex market to protect themselves against adverse currency movements. This is called ‘hedging’.  If a European company knows it has $10m dollars in invoices due in over the next six months, it will often lock in at today’s exchange rate for the sake of certainty.

To do this, they use ‘forward contracts’. These are derived from the spot price, but will differ slightly according to the length of time the exchange rate has to be locked in for.

So now that you understand the players, the real trick comes down to the following.
Retail traders are often right over the medium term timeframe, but they are more often than not wrong in the longer term trends, where the real money is made. Therefore you should generally play against them in longer trends, remembering the two adages “don’t follow the crowd” and “the trend is your friend”.

Banks will take small losing positions to earn good commissions, but tend to be right on any of the big moves. Therefore you want to try and follow them.

One final note of caution. Be on the lookout for central bank action. They have the power to override the whole market just by using a well-placed sentence, so be sure you know when high-profile meetings and press conferences are scheduled (by regularly checking the Economic Calendar). These are always likely to impact the market direction.

Summary of Central Banks Interest Rates Feb 2017

summary of interest rates february 2017

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