The concept of trading currencies is simple, once it is realized that a currency is a commodity whose value fluctuates against another currency. By buying (or selling) a currency, Traders look to earn a profit from the movement in the exchange rate. The beauty of currency trading is that the cost of trading is low. This means that trades can be transacted for the extreme short-term, literally seconds, as well as for a longer duration.
A trader believes the EUR is about to increase in value against the USD and buys €1 million at 1.5000. Shortly after, the rate is 1.5050 and the trader closes the position for a US $5,000.
€1,000,000 at 1.50 = US $1,500,000
€1,000,000 at 1.5050 = US $1,505,000
Difference = Profit of US $5,000
There are around 180 currencies in the world. However, activity is concentrated into six ‘major’ currency pairs, which account for around two-thirds of the total turnover.
The Majors are:
Currencies market is a global market that never sleeps. It is active 24-hours a day for 5 days a week. Most activity takes place between the time the New Zealand market opens on Monday, which is Sunday evening in Europe until the US market closes on Friday evening.
In foreign exchange, one currency is always quoted against another. The ‘base’ currency is the one that can be thought of as the reference. For instance, in a EUR/USD quote, EUR is the base currency and the quote defines how many USD it costs to buy. Similarly, in USD/JPY, USD is the base currency and the rate defines how many JPY it costs to buy.
The Bid is the price the market is willing to pay for a certain currency pair. The offer, or ask price, is the price it is prepared to sell at.
For example, in a USD/CHF quote of 1.1650/1.653, the bid is 1.1650, while the offer is 1.1653. Frequently, quotes are abbreviated to just the small number. In this case, a phone quote would be 50/53.
The difference between the bid and ask is known as the spread.
A “Pip” (price interest point) represents the smallest fluctuation in price of a currency pair. For most currencies, the rate is quoted to the fourth decimal place, with USD/JPY the notable exception. A pip represents 1/10,000th or 0.0001 of the counter currency. A change of 1 pip for GPB/USD at 1.6319 is 1.6320. The Pip for USD/JPY is only quoted to the second decimal point (1/100th or 0.01).
The currencies market 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 via an electronic network of banks, brokers, corporations and individuals trading one currency for another.
Currency 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. Currencies exchange rates quoted between banks are referred to as Inter-bank rates.
At first glance, this ad-hoc arrangement can look like the wild west to investors who are used to organized exchanges. But be reassured, this arrangement works exceedingly well in practice: because participants in currencies must both compete and cooperate with each others, they provide very effective control over the market.
Leverage trading simply means that you are permitted to trade many times the size of your margin deposit. This is primarily attributed to the higher levels of liquidity.
For instance, a leverage of 1:100 means, in order to buy and benefit from one lot of 10,000 US dollars you only have to commit your 100 dollars, the rest of the amount is leveraged by the broker.
While certainly not for everyone, the substantial leverage available with most online brokers in the currencies market is an essential attribute of this market. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the currencies market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.
Leverage is both way weapon: on one hand, it lets traders profit from a lot size much larger than their investments. But on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker - that's right - but that's not all: a too small leverage can be equally dangerous.
The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to diligently implement risk management in your trading plan. You have to devise and adhere to a system where your controls kick in when emotion might otherwise take over.
Currencies are traded in units of currencies which are grouped in lots. At a retail level, lots are divided into several categories: the so-called 'full-size' or 'standard' lots, 'mini' lots, and 'micro' lots.
A standard lot consists of 100,000 units of whatever the base currency in the currency pair is. A mini lot consists of 10,000 units of the base currency and a micro lot 1,000 units of the base currency. As you can see, a mini contract is one-tenth the size of a standard contract and the micro lot one-tenth of the mini lot.
So for instance, when buying one micro lot on the GBP/USD, you would buy 1,000 British Pounds and sell an equivalent amount of US Dollars.
Let's suppose the current exchange rate for GBPUSD is 2.4500 and you want to buy 10,000 US Dollars worth of this pair. Here's the math:
For pairs with USD as the quote currency, take the dollar amount you want to purchase and divide it by the exchange rate:
(desired position size) / (current rate) = # of units
100,000 US Dollars / 2.4500 = 40,816.32 units of GBPUSD
As you can see, this is approximately 4 mini lots of British Pounds rounded down.
Buying a pair with USD as the base currency is much easier to calculate. Why? Because in these cases you just buy the number of units you want because you are purchasing US dollars, the base currency.
And in the case of a cross pair transaction, when buying 100,000 US dollar worth of GBPCHF, for instance, we purchase 40,816.32 units of GBPUSD at the above rate and sell 100,000 units of USDCHF.
Being able to choose among several lot sizes is a huge advantage retail currencies trading offers to the small investor. It allows you to tailor and fine tune your money management to better meet your trading style.
If you have a small account size keep your risk profile low by choosing to trade with mini lots. Even many seasoned traders avoid standard contracts to be more precise in their position sizing.
Can I still trade currencies if the lot sizes are much superior to my account size? Yes. And not only that: by trading whatever size of lots you will gain or lose profits as though that money was in your account. Making use of the leverage effect permits a trader to control a large amount of capital with a comparatively small amount of capital. This is called margin trading.
Nevertheless, margin trading is a double-edged sword: it can lead to large gains but conversely, it can cause large losses if the exchange rate moves against the anticipated direction.
Most modern platforms, such as Blue Suisse’s MetaTrader 4, MetaTrader 5 or Problue trader, automatically calculate a trader’s profit and loss (P&L) on open positions. This allows traders to keep track of the market movements. Understanding how these calculations work is crucial for all traders.
Sold 3 lots of EURUSD at 1.2175 and bought them at 1.2110:
In this example, the client made 65 pips * 3 lots = 195 pips in total profit (as he sold at a higher price than he bought). The pip value for EURUSD is US $ 10, so the total profit =195 pips * US $ 10 per pip = US $ 1,950.
Bought 2 lots of USDJPY at 105.60 and sold them at 105.20:
In this example, the client made 40 pips * 2 lots = 80 pips in total loss (as he sold at a lower price than he bought). The pip value for USDJPY is 1000 JPY and this equals 1000 / 105.20 (price of USDJPY when the position was closed) = US $ 9.506 approximately, and so the client total loss = 80 pips * US $ 9.506 per pip = US $ 760.46.
Sold 2 lots of EURGBP at 0.7015 and bought them at 0.6940:
In this example, the client made 75 pips * 2 LOTS = 150 pips in total profit. The pip value for EURGBP is 10 GBP and this equals 10 * 1.8500 (assuming the price of GBPUSD was 1.8500 when the position was closed) = US $ 18.50, and so the total profit is 150 pips * US $ 18.50 per pip = US $ 2775.
Fundamental analysis is the application of micro- and macro-economic theory to markets to predict future trends. Major fundamental forces are frequently one of the key drivers of currency rates.
The following are a list of key US economic indicators:
The trade balance reflects the difference between a nation's exports and imports of goods. A positive trade balance, or a surplus, occurs when a country's exports exceed imports. A negative trade balance, or a deficit, occurs when more goods are imported than exported.
Trade balances are closely followed by players in currency markets, because of the influence they can have. It is often used as an assessment of the overall economic activity in a country’s or region’s economy. Export activities not only reflect the competitive position of the country in question, but also the strength of economic activity abroad. Trends in the import activity reflect the strength of domestic economic activity.
A country that runs a significant trade balance deficit tends to generally have a weak currency. However, this can be offset by substantial financial investment inflows.
The current account is an important part of international trade data as it is the broadest measure of sales and purchased goods, services, interest payments and unilateral transfers. The trade balance is contained in the current account. In general, a Current Account deficit can weaken the currency.
The Consumer Price Index (CPI) is a measure of inflation. It takes the average level of prices of a fixed basket of goods and services purchased by the consumers.
CPI is a primary inflation indicator because consumer spending accounts for nearly two-thirds of economic activity. A rising CPI is often followed by higher short-term interest rates, which can be supportive for a currency in the short term. However, if inflation becomes a long-term problem, confidence in the currency will eventually be undermined and it will weaken.
Durable goods orders are a measure of the new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. Monthly percent changes reflect the rate of change of these orders.
The durable goods orders index is a major indicator of manufacturing sector trends. Rising durable goods orders are normally associated with stronger economic activity and can lead to higher short-term interest rates, which is usually supportive for a currency.
Gross domestic product (GDP) is the broadest measure of aggregate economic activity available. It is an indicator of the market value of all goods and services produced within a country. GDP is reported quarterly and it is followed very closely as it is the primary indicator of the strength of economic activity.
The GDP report has three releases:
1) advance release (first);
2) preliminary release (1st revision);
3) final release (2nd and last revision).
These revisions usually have a substantial impact on the markets.
A high GDP figure is usually followed by expectations of higher interest rates, which is mostly positive for the currency concerned at least in the short term, unless there are also inflationary pressures.
In addition to the GDP figures, there are the GDP deflators, which measure the change in prices in total GDP as well as for each component. The GDP deflators are another key inflation measure beside the CPI. In contrast to the CPI, the GDP deflators have the advantage of not being a fixed basket of goods and services, which means that changes in consumption patterns or the introduction of new goods and services will be reflected in the deflators.
Housing Starts measure initial construction of residential units (single-family and multi-family) each month. Housing Starts are closely watched as it gives an indicator of the general sentiment in the economy. High construction activity is usually associated with increased economic activity and confidence and can be predictive of higher short-term interest rates.
The Payroll employment (also known as the Labor Report) is currently regarded as the most important among all US economic indicators. It is usually released on the first Friday of the month. The report provides a comprehensive look of the economy and it is a measure of the number of people being paid as employees by non-farm business establishments and units of government. Monthly changes in payroll employment reflect the net number of new jobs created or lost during the month and it is widely followed as an important indicator of economic activity.
Large increases in the payroll employment are considered signs of strong economic activity that could eventually lead to higher interest rates, which is generally supportive of the currency at least in the short term. If, however, it is estimated that an inflationary pressure is building up, this may undermine the longer term confidence in the currency.
The Producer Price Index measures the monthly change in wholesale prices and is broken down by commodity, industry, and stage of production.
The PPI gives an important inflation indication as it measures price changes in the manufacturing sector – and inflation at the producer level often gets passed straight through to consumers.
Technical analysis is another method of forecasting prices. It studies past price action in an attempt to predict the future. The technical analyst focuses exclusively on market information and works on the assumption that all fundamental information is already reflected in the price. Unlike the fundamentalist, the technician attempts to predict future price directions by searching for established patterns of price behaviour that have signalled major movements in the past.
Charts are the major tool in technical analysis. The following is an introduction to the most common technical analytical tools used to identify trends and recurring patterns in a volatile market.
There are three main types of charts used in technical analysis:
Line Chart: The line chart is a graphical depiction of the exchange rate history of a currency pair over time. The line is constructed by connecting daily closing prices.
Bar Chart: The bar chart is a depiction of the price performance of a currency pair, made up of vertical bars at set intraday time intervals (e.g. every 30 minutes). Each bar has 4 'hooks', representing the opening, closing, high and low (OCHL) exchange rates for the time interval.
Candlestick Chart: The candlestick chart is a variant of the bar chart, except that the candlestick chart depicts OCHL prices as 'candlesticks' with a wick at each end. When the opening rate is higher than the closing rate the candlestick is 'solid'. When the closing rate exceeds the opening rate, the candlestick is 'hollow'.
One use of technical analysis is to derive "support" and "resistance" levels. The underlying idea is that the market will tend to trade above its support levels and below its resistance levels. A support level indicates a specific price level that the currency will have difficulties crossing below. If the price repeatedly fails to move below this particular point, a straight line pattern will appear.
Resistance levels on the other hand, indicates a specific price level that the currency will have difficulties crossing above. Recurring failure for the price to move above this point will produce a straight line pattern.
If a support or resistance level is broken, the market is expected to follow through in that direction. These levels are determined through analysis of the chart and by assessment of where the market has encountered unbroken support or resistance in the past.
Moving averages provide another tool for tracking price trends. A moving average is in its simplest form an average of prices that rolls over time. A 10-day moving average is calculated by adding the last 10 days’ closing prices and then dividing them by 10. On the following day, the oldest price is dropped, and the new day’s closing price is added instead; now these 10 prices are divided by 10. In this way, the average "moves" each day.
Moving averages provide a more mechanical approach to entering or exiting the market. To help identify entry and exit points, moving averages are frequently superimposed onto bar charts. When the market closes above the moving average, it is generally interpreted as a buy signal. It is in the same way considered a sell signal when the market closes below the moving average. Some traders prefer to see the moving average line actually change direction before accepting it as a buy or sell signal.
The sensitivity of a moving average line and the number of buy and sell signals it produces is directly correlated with the chosen time period for the moving average. A 5-day moving average will be more sensitive and will prompt more buy and sell signals than a 20-day moving average. If the average is too sensitive, traders may find themselves jumping in and out of the market too often. On the other hand, if the moving average is not sensitive enough, traders risk missing opportunities by identifying buy and sell signals too late.
Moving averages can be extremely useful tools for the technical trader.
A trend line helps identify the trend as well as potential areas of support and resistance. A trend line is a straight line that connects at least two important peaks or troughs in the price action of an underlying tradable. No other price action must break the trend line between the two points. In this way a trend line marks a support or a resistance area where the price has turned (peaks and valleys) and has not been violated. The longer a trend line the more valid it is, especially if price has touched the line several times without penetration.
The penetration of a long term trend line may be an indication that a reversal of the trend is about to occur. However, there is no guarantee that this will happen. As with all indicators of a price trend reversal, there is no proof method that predetermines where future prices will go.
A double or a triple bottom formation also provides a good level for a technical sell-stop order. Such a sell-stop order would normally be placed just below the prior lows. Likewise does a double or a triple top formation provide a good level for a technical buy-stop order just above the prior highs.
When a market is moving swiftly in a given direction, it may sometimes pull back as market participants take their profits. This phenomenon is known as a retracement often it presents a good opportunity to re-enter the market at more attractive levels before the underlying trend resumes.
Using Fibonacci ratios is a common way of measuring retracements.
Appreciation: A currency appreciates when it strengthens in price.
Ask Rate: Also known as the offer, this is the rate at which non-market makers can buy a particular currency.
Asset Allocation: Investment practice that divides funds among different markets to achieve diversification for risk management purposes.
Balance of Trade: The value of a country's exports minus its imports.
Base Currency: The currency which is the base for quotes. For example, the euro is the base currency for EURUSD quotes, while the US dollar is the base currency for USDJPY.
Bear Market: A market that is characterized by declining prices.
Bid Rate: The rate at which traders can currently sell a particular currency.
Bid/Offer (Ask) Spread: The difference between the bid and the ask (offer) price.
Broker: An individual or a company that acts as an intermediary, handling investors' orders to buy and sell currencies. Some brokers charge commission for this service.
Bull Market: A market that is characterized by rising prices.
Cable: Slang for the GBPUSD dollars exchange rate.
Central Bank: A government or quasi-governmental organization that manages a country's monetary policy. An example is the Federal Reserve, which is the US Central Bank.
Commission: A transaction fee charged by a broker.
Cross Rate: An exchange rate between two currencies that does not involve the US dollar, such as EURJPY.
Currency: Any form of money issued by a government or central bank and used as legal tender.
Currency Risk: The probability of an adverse change in exchange rates.
Day Trading: Refers to positions that have been opened and closed on the same day.
Deficit: A negative balance of trade or payments.
Economic Indicator: A government issued statistic that indicates current economic growth and stability. Common indicators include employment rates, Gross Domestic Product (GDP), CPI (inflation) and retail sales.
European Central Bank (ECB): The Central Bank of the European Monetary Union.
Federal Reserve (Fed): The Central Bank of the United States.
Foreign Exchange market: A market where currencies are bought and sold against each other.
Fundamental analysis: Analysis of economic and political information with the objective of determining future movements in a financial market.
Futures Contract: An obligation to exchange a good or an instrument at a set price on a future date. The main difference between a future and a forward is that futures are typically traded on an exchange to a fixed settlement date. Forwards are over-the-counter (OTC) contracts and the maturity date can be defined on a bespoke basis.
Hedge: A position or a combination of positions that reduces the risk of the trader's primary position.
Inflation: An economic condition whereby prices for consumer goods rise, eroding purchasing power.
Limit order: An order to buy at or below a specific price or to sell at or above a specific price.
Liquidity: The ability of a market to accept large transaction with minimal or no impact on price stability.
Long position: A market position where the client has bought a currency he did not previously have. Normally expressed in base currency terms, e.g. long Dollars (short Swiss Franc)...
Margin: The required equity that an investor must deposit to collateralize a position.
Margin call: A request from a broker or a dealer for additional funds or other collateral to guarantee performance on a position that has moved against the customer. Alternatively the client can choose to close one or more positions.
Market Maker: A dealer who supplies prices and is prepared to buy or sell at those stated bid and ask prices.
Offer: The price or rate that a trader is prepared to sell at.
Open position: A deal that has not been settled by physical payment or reversed by an equal and opposite deal for the same value.
Over the Counter (OTC): Used to describe any transaction that is not conducted over a regulated exchange.
Pips: The term used in the currency market to characterize the smallest incremental move an exchange rate can make. The value of a pip depends on the currency pair. One pip/basis point equals for instance 0.0001 for EUR/USD, GBP/USD and USD/CHF, and 0.01 for USD/JPY.
Resistance level: A price level at which you would expect selling to take place.
Short Position: An investment position that benefits from a decline in market price.
Spot Price: The current market price. Settlement of spot transactions usually occurs within two business days.
Spread: The difference between the bid and the offer (ask) price.
Stop order: An order to sell at or below a specific price or to buy at or above a specific price.
Stop loss: An order to close a position when a particular price is reached in order to minimize loss.
Support Level: A price level at which you would expect buying to take place.
Take profit: An order to close a position when a particular price is reached to ensure a profit.
Technical Analysis: An effort to forecast future market activity by analysing market data through the use of charts, price trends, and volume.