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foreign currency trading

Page history last edited by Brian D Butler 13 years, 7 months ago

 

 

 

 

 

 

Foreign Currency trading:

 

This is our how-to guide for currency trading.  In our other pages in KookyPlan we outline more of the theoretical apects of Currency (what is it, how are values set, what are the implications for international business), Futures market (for currency hedging, speculating), Foreign exchange Optionsforward contracts and much more.

 

But, in this page, we are going to look specifially at the pratical aspects of "how to" trade foreign currencies.

 

 

Note:  this page is for practical how-to tips for FX trading.  If you are looking for  Other currency-related pages from GloboTrends:

 

 

 

 

Table of Contents:


 

 

 

 

Where to trade foreign exchange?

 

exchange:

1.  Chicago Mercantile Exchange:  CME 

 

Online

2.  http://www.forex.com/

3.   http://fxtrade.oanda.com/

and, many, many more... (search google for FX, or Forex)...

4.  new market:  ETFs for currency?

5.  foreign currency denominated deposits (and bonds); https://www.everbank.com/

 

 

 

What are exchange rates:

 

Please see our discussion on Currency.   Summary here:  In finance, the exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 123 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 123 is worth the same as USD 1. 

 

 

Biggest FX traders:

  • Barclays Capital, the world’s third-largest foreign-exchange trader.

 

 

Finding current currency exchange rates:

 

 

 OANDA foreign exchange map

 

Currencies:

 

 

Asian Currency Unit - ACU COP
CRC CUP
CVE CYP
CZK DJF
DKK DOP
EEK EGP
ETB EUR
Euro FJD
FKP GBP
GHC GIP
GMD GNF
GTQ GYD
HKD HNL
HTG HUF
IDR ILS
INR IQD
IRR ISK
JMD JOD
JPY KES
KHR KMF
KPW KRW
KWD KYD
KZT LAK
LBP LRD
LSL LTL
LVL LYD
MAD MMK
MNT MOP
MRO MTL
MUR MVR
MWK MXN
MYR MZM
NAD NGN
NIO NOK
NPR NZD
OMR PAB
PEN PGK
PHP PKR
PLN Punt
PYG SBD
SCR SDD
SDP SEK
SGD SHP
SIT SLR

 

 

 

 

Hedging currency risk

 

To protect yourself from unwanted risk of currency movements...please visit our discussion on currency hedging

 

 

Speculating on future trends

 

To guess where the FX rate is going...use either chartist methods or economic theories... predicting trends in foreign exchange rates

 

The key driver to determine whether a currency appreciates or depreciates in the market is CONFIDENCE.  If traders continue to have confidence in the economic growth / stability of a country, then they will continue to demand that currency.  For example, when US economy is slowing down, and the Fed cuts interest rates, the indication is less confidence in the sustainability of the US economy, so less confidence should yield a depreciation of the currency.

 

The two main drivers, besides "confidence" that effect FX rates are interest and inflation, but always remember: "interest" forces are always faster / stronger than "inflation" forces.  Because the financial system moves quickly to take advantage of interest, but the prices of common goods adjust more slowly.   With that said....here is a discussion about many variables that work together to help set FX rates. 

 

Read more:  predicting trends in foreign exchange rates

 

 

 

Simple Trading Strategies

 

 

 

Simple Trades:

 

 

Definitions in FX trading

 

 

NDF's  Non Deliverable Forwards

 

a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It is used in various markets such as foreign exchange and commodities. NDFs are prevalent in some countries where forward FX trading has been banned by the government (usually as a means to prevent exchange rate volatility).

read more:  http://en.wikipedia.org/wiki/Non-deliverable_forward

 

 

What is the Foreign Exchange Market   

 

The foreign exchange market is the largest financial market in the world. By some estimates, about 2 trillion USD worth of currency changes hands every day. While trading can occur anywhere, the major centers for trading are in London and in New York. The majority of trading is done inside of the major commercial and investment banks around the world.

 

While in theory, you can trade any currency directly with another, in reality most trading is done with the US Dollar as an intermediary. For example, if you wanted to convert Brazilian Reais to Malaysian Ringgits, you would first trade Reais with Dollars, and then Dollars with Ringgits. So, most currencies are quoted in terms of the USD, which is done for two reasons. (1) it reduces the number of cross-currency quotes, and (2) it reduces the chance for traders to take advantage of triangular arbitrage.

 

 

  • Direct quotation - 1 unit of foreign = $(x) USD - quoted "in terms of USD". Example: $1.41 USD / Euro is direct, in Dollar terms
  • Indirect quotation - (x) units of foreign = $1 USD - quoted in European terms. Example: R$2: $1 USD (two Brazilian Reais to one US Dollar) is "indirect" and quoted in Foreign terms.

 

 

Currencies are traded in a market place, similar to how stocks are traded. The way to that a price goes up or down is directly related to the supply and demand of that currency in the FX market. Trades outside of the FX market (and just internal to a particular country) will not affect the value of the currency. So, it doesn’t matter how much trading there is within a country, but rather how much trading there is between countries.

 

In this global FX market, the values of the various currencies are determined every second of the day by constant changes in the supply and demand on those currencies. If the demand is high, relative to the supply, then the value of the currency will appreciate. If the demand is low, but there are lots of people looking to sell, then the value of the currency will fall.

 

The easiest aspect of the FX system to understand is when one country exports their products to another country, and therefore imports currency. When the importing country (for example the USA) wants to purchase goods from an exporting country (Japan for example), then the importer will first need to buy Japanese Yen on the FX market (selling USD). That event, if multiplied a million times over, could have an impact on the currency rates of the two countries, driving down the value of the USD (selling) and driving up the value of the Japanese Yen (buying).

 

While product sales are an obvious and easy to understand part of the FX market, they actually only play a small part in the over all currency picture. There are many other reasons that international traders might want to buy one currency or sell another on the FX market. But no matter what the reasoning behind the buy/ sell of a currency, you have to remember that the value of a currency is solely determined by the supply and demand within the FX market.

 

If a trader were to speculate that a value of a currency will appreciate, they can (and do) trade that currency purely as a speculative investment. Once the currency has appreciated to a level where they think it will depreciate, they sell. This type of speculative trading in the FX market is a huge business. Many banks have special trading floors especially set up just to manage their currency trading operations. In addition to professional trading floors at commercial banks, there are many international companies that speculate as means of “hedging” their currency risk. This means that they might be afraid that a currency will change in value, so they will buy or sell futures contracts allowing them to lock in at various levels, and thus mitigating their currency risk. Once these futures come due, then a company (like GE for example) might sell a large position in a particular currency and could have enough volume to affect the markets.

 

Governments also have the ability to affect the level of their own (or others) currencies by buying or selling on the FX market. China is a classic example of a government that is buying USD and selling their own currency in an effort to keep their currency value low (and effectively keep the US currency high). A government can also step in when the market becomes “disorderly”. This is typically done through the Fed as a means of “correcting” some market “imperfections”.

 

No matter what the reason, or who is doing it (governments, large corporations, speculators, hedge funds, mutual fund managers, or commercial banks) the net result is always the same…a particular value for a currency will ultimately be determined by the market place. Simple supply and demand. If people want your currency to conduct transitions (for whatever purpose) then your currency will appreciate.

 

One final note: internal economic situations of a country can also have an effect on the international FX market in that either inflation or interest rates can drive investment either into or out of a country. It is fairly well established that a country that has rising interest rates (in relation to other countries) will see an inflow of investment capital as the relative return on capital will appear that much better. On the other hand, an increase in inflation will typically see an outflow of investment capital out of a country as investors flee the potential loss of investment value. An inflow of capital will be accompanied with a respective appreciation in the currency (rising interest rate example), while an outflow of capital will be accompanies with depreciation (inflation example).

 

 

 

 

Who are the traders?

 

  • Professional traders at commercial and investment banks
  • Foreign exchange brokers who match up the buy / sell orders
  • Importers / Exporter who need each others currency to pay for products / services
  • Portfolio managers who buy and sell foreign stocks and bonds

 

 

Source: BIS Triennial Survey 2007

 

 

Source: BIS Triennial Survey 2007

 

US dollar as the most traded currency:

 

 

N.B. Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%.

Source: BIS Triennial Survey 2007

 

 

 

Fixed / Floating Exchange rate regimes: 

 

There are two basic systems (polar opposites), and many in-between hybrids:

 

 

In a Floating Exchange Rate system, the value of a Currency is set in a similar way as any other asset. The main determinant of value is our perception of what we expect the value to be in the future. This future value depends on the interest rate that is offered, and the expected change against other currencies. As with other assets, the saver is willing to hold a currency if they expect a higher rate of return than can be obtained by holding a different asset (in this case, a different currency). The interest rates are important in FX trading because assets deposited in foreign countries can earn interest.

 

example: if you had the choice of putting your money (for one year) in the US bank at 11% interest, or in Europe at 6% interest, which would you choose? The answer depends upon the exchange rates available, and the amount of depreciation expected over the next year. If you knew that the dollar would depreciate by 6%, then the better investment would be the Euro. Think of it like this...the US investment would make 11% in the bank, but would loose 6% because of the currency, so its real interest rate was only 5%, which is less than the 6% you could have made in Euros. To put these interest rates in dollar terms, you would add the expected dollar depreciation to the Euro interest rate. That way, you would be comparing the 11% interest in the US, with 12% in Europe (6%+6%).

 

note: London, UK is the biggest market for FX trading

 

In order to compare to interest rates from one currency vs. another, it is advisable to find a way to eliminate the effects of different bank risk, country risk, etc. The interest rates that you should use for predicting FX rates in the future / forward markets is in the London Eurocurrency rates (see below for more discussion).

 

 

 

How to guide for traders:

 

 

Foreign Exchange describes the purchase of a particular currency from an individual or institution and the simultaneous sell of another currency at the equivalent value or current exchange rate. Essentially, the process of exchanging one currency for another is a simple trade based on the current rates of the two currencies involved.

 

At the core level of the world’s need for money exchange is the international traveler. When traveling from the US to England, for example, you will of course need the local currency to pay for transportation, food, and so on. Upon arrival at the airport you will surrender (sell) your US Dollars in order to receive (buy) the equivalent in British Pounds. In this example, you sold the USD and bought the GBP, conversely the foreign exchange counter bought the USD and sold the GBP. The prices at which you buy and sell currencies at are known as exchange rates. This rate or price fluctuates based on demand, political, and economic events surrounding each country’s currency.

 

The example above illustrates foreign currency trading in basic terms as it relates to world travelers. However, the market is also utilized globally by each country's central bank (i.e., America's Federal Reserve), investment and commercial banks, fund management firms (mutual funds and hedge funds), major corporations, and individual investors or speculators. Depending on the timing of such transactions, purchasing a currency with the intent of later selling it at a better exchange rate (and vice versa) can potentially yield profits for investors, of course there is a strong potential for loss trading currencies as well.

 

Utilization by so many parties is why the Foreign Exchange market is the world's largest financial market, with a daily dollar volume exceeding $1.9 trillion ($1,900,000,000,000). This mind boggling volume is probably what led you to research the topic.

 

Now let's put the market's trading volume in perspective. In 2003 the reported trading volume for the NYSE (New York Stock Exchange) was a mere $9.6 trillion; the previous year was just above that at $10.2 trillion. These seem like respectable figures, but in comparison to the Foreign Exchange Market, which is commonly trading $1.9 trillion in a single day, these numbers pale in comparison. This is probably why so many fund managers and Fortune 500 companies invest heavily in this highly liquid market. The high volume of this market makes it one of the riskiest markets to trade in.

 

It is important to note that retail traders, such as yourself, will most likely be accessing the off-exchange foreign currency market (or Forex market) via an FCM (Futures Commissions Merchant) or broker. You will not be trading in the actual Interbank market itself. Your access to the total market will be determined by your chosen broker’s limitations. FCMs or brokers act as a bridge between you and their liquidity partner (sometimes larger global banks) that you would otherwise not have sufficient capital to do business with. The large majority of off-exchange retail foreign currency brokers act as market makers, meaning that by keeping many trades in house they create their own liquidity. Some retail brokers clear trades directly through to the larger banks that provide their liquidity. If you are new to the Forex market it would wise to research and understand your broker’s particular business model and method of clearing trades.

 

Unlike other financial markets, the Forex market operates 24 hours a day, 5.5 days a week (6:00 PM EST on Sunday until 4:00 PM EST on Friday). Through an electronic network of banks, corporations and individual traders exchange currencies, though as the market is primarily used as a means for speculative investing, actual physical delivery of currencies is almost never intended. Forex trading begins every day in Sydney, moves to Tokyo, followed by Europe and finally the Americas.

 

 

"Bid" vs. "Ask"

Foreign Exchange prices, or quotes, include a "Bid" and "Ask" similar to other financial products. Bid is the price at which a trader is able to sell a currency pair. The Bid price or sell price of a currency pair is always the lower price in a quote. Ask, sometimes referred to as "Offer", is then the price at which traders are able to buy a currency pair. In other words, Forex traders always buy at the high and sell at the low of a price quote. The difference between the Bid and Ask is called the "Spread" or "Pip Spread", which is the Trader’s cost per trade or per transaction. There are typically not additional broker commissions involved in trading the Forex market, as there might be when trading other investment markets.

 

Reading a foreign exchange quote may seem a bit confusing at first. However, it’s really quite simple if you are able to remember two things:

 

1) The first currency listed is the base currency

2) The value of the base currency is always 1 (one)

 

A quote of USD/JPY at 116.04 is to say that 1 US Dollar (USD) = 116.04 Japanese Yen (JPY). When the US dollar is the base unit and a currency pair’s price increases, comparatively the dollar has appreciated and the other currency in the pair (usually known as the cross currency) has weakened. Using the above USD/JPY example as a reference, if the USD/JPY increases from 116.04 to 117.51 (147 pips), the dollar is stronger because it will now buy more yen than before.

 

There are four currency pairs involving the US dollar in which the US dollar is not the base currency. These exceptions are the Australian dollar (AUD), the British Pound (GBP), the Euro (EUR), and the New Zealand dollar (NZD). A quote on the GBP/USD of 1.7600 would mean that one British Pound is equal to 1.7600 US dollars. If the price of a currency pair increases the value of the base currency in comparison to the cross currency thus increases. Conversely, if the price of a currency pair decreases, such is to say that the value of the base currency in comparison to cross currency has weakened.

 

What Influences Prices

 

Foreign exchange markets and prices are mainly influenced by international trade and investment flows. The Forex market is also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions, especially interest rates, inflation, and political stability, or as if often the case, political instability. Though economic factors do have long term affects, it is often the immediate reaction that causes daily price volatility, which makes Forex trading very attractive to intra-day traders. Currency trading can offer investors another layer of diversification. Trading currencies can be viewed as a means to protect against adverse movements in the equity and bond markets, movements that of course also impact mutual funds. You should bear in mind that trading in the off-exchange foreign currency market is one of the riskiest forms of trading and you should only invest a small portion of your risk capital in this market.

 

24-Hour Trading

 

Forex is a true 24 hour market, which offers a major advantage over equities trading. Investors are able to trade at odd hours, thus allowing more flexibility for personal, business and social activities. Whether trading at 8am, 2pm, or even 2am, there will always be buyers and sellers actively trading foreign currencies. Such flexibility allows traders to immediately respond to breaking news and other political factors driving the market.

 

After hours trading in the equities market has several limitations. In the US, for example, equities traders have access to ECNs (Electronic Communications Networks), also known as “matching systems”. These networks are established to provide a method for equities traders to buy and sell amongst each other. Such networks are usually not able to offer as tight of spreads as would be offered during normal market hours, thus most trades are not executed at a fair market price, subsequently there is no guarantee that every trade will be executed.

 

Unmatched Liquidity

 

An investment market with lacking liquidity, or a lack of buyers and sellers at certain times, is often the demise of traders who need in or out of the market without delay. The global network of governments, banks, corporations, hedge funds, and individual traders that collectively drive the Forex market, are in essence, also driving the world’s largest network of liquidity. Such high trade volume works to ensure trade execution and the stability of prices, regardless of the time of day.

 

Equities traders, on the other hand, are more susceptive to liquidity risk and are subject to potentially wider dealing spreads and larger price movements. Liquidity in the equities market really does pale in comparison to that of the Forex market.

 

High Leverage

Leverage is the key to understanding the risk associated with trading the Forex Market, and of course, the potential for gain. Many Forex brokers offer leverage as high as 200 – 1, meaning that $50 of margin would control a $10,000 position in the market (this is an example of a mini lot). Forex trading is often attractive to investors coming from the equities market because Forex trading offers such high leverage. It is important to understand why Forex brokers offer higher leverage, and of course… the dangers associated with such.

 

To some extent, higher leverage is a necessary evil in the Forex market. It can offer advantages over equities trading, but only if it is properly understood and utilized. Though currency values on a global stage are constantly in a state of flux, high liquidity and market stability translate to relatively small daily price movements. In fact, average daily movement is around 1% on most major pairs. Compare that to the equities market, where average daily movements are closer to 10% and it is not hard to understand why large contracts are needed in order to yield profits on intraday price movements.

 

Without high leverage most retail investors would not be able to afford trading in the Forex market. However, with increased buying power comes increased risk. Traders who are new to the market often make the mistake of over-trading their account. Because relatively small margin is required to open large positions beginning traders often make the mistake of opening too many positions at one time. A quick market move can then result in substantial losses. Interbank FX would advise any trader new to the Forex market to trade only a very small percentage of their account at any one time.

 

Profit Potential in Both Rising and Falling Markets

Like any market, there is always a buyer and a seller the world of currencies. The potential for profit will of course rally between the buyers and sellers, the longs and the shorts. Trading currencies in pairs offers the advantage of speculation from either side, but it is the volatility in combination with excellent liquidity that offers currency investors a true advantage over any other market. Regardless of the time of day, traders in the Forex market can long or short any currency pair of their choice. Many brokers also offer hedging, meaning that traders can take a long and short position on the same currency pair. The market’s volatility provides the constant potential for gain, and of course, the constant potential for loss as well. Forex trading can be risky, but execution in or out of trades should not be a problem when trading through a reputable broker. Equities traders, on the other hand, may have a much more difficult time liquidating stocks when the market is moving against them.

 

Understanding Currency Pairs

 

The Majors

 

Most currency transactions involve the "Majors" consisting of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). Many traders are beginning to add the Canadian Dollar (CAD) and the Australian Dollar (AUD) to this category as well.

 

Cross Currency Pairs

Currency pairs that do not include the US dollar are referred to as Cross Currency Pairs. Cross Currency trading can open a completely new aspect of the Forex market to speculators. Some cross currencies move very slowly and trend very well, ideal for beginning traders. Other cross currency pairs move very quickly and are extremely volatile; with daily average movements exceeding 100 pips.

 

Speculators might utilize cross pairs as a means of portfolio diversification. An example would be an investor whose portfolio is primarily comprised of US based stocks and bonds who wants to diversify into foreign markets. Holding carry trades in cross currencies might be a good option for this type of investor. Many of these cross currencies also offer greater return potential with enhanced interest (also referred to as swap, rollover interest or carry forward interest) that can be paid on open positions. Swap is a credit or debit as a result of daily interest rates. When traders hold positions over night, they are either credited or debited interest based on the rates at the time. Often, cross currencies yield higher interest rates than do major currencies and are traded for the purpose of collecting said interest.

 

What is Margin

In the Forex market the term margin is most often referring to the amount of money required to open a leveraged position, or a contract in the market. It may also be used to describe the type of account, i.e. margin account; meaning that an account is being traded on borrowed funds. It is generally safe to assume that all off-exchange retail foreign currency (or Forex) traders are trading within margined accounts. Without leverage, or the ability to trade on borrowed funds, a trader placing a standard lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed. Trading with a margined account allows traders to utilize leverage, meaning that the same $100,000 contract can be placed for an amount of margin determined by the set level of leverage. An account at 100:1 leverage would require $1,000 of margin to place a $100,000 trade.

 

Read more: http://www.ibfxu.com/Courses/FXM/fxm1010.aspx 

 

 

 

 

 

 

 

 

 

 

 

 

 

Links from KookyPlan

 

 

 

 

Innovative Companies involved in FX market

 

eToro

 

 
 

Foreign exchange market (FX)

largest market in the world.  Over $2 trillion traded per day.  This is larger than any stock exchange.  The largest traders are banks, with trades of $50 million at a time.  C.H.I.P.S. = Clearing house international, in New York.  One bank to another bank.  93% of all FX market is bank to bank trading.   CEMEX, GE, and all other Fortune 500 comanies are not important in FX market, as they only make up 7% of the market.  FX brokers are involved in 50% of all bank-to-bank trades.  There are 12 brokers in NY, London, Tokyo that are mostly used.  They are not a buyer / seller, but instead act as an intermediary.  They dont tell the banks who they are trading with untill after the trade is complete. 

 

Main dealers:  portfolio investors, speculators, and arbitragers (who play difference in rates between London / New York markets, and keep doing until drive the market to the same).

 

Source: BIS Triennial Survey 2007

 

 

 

Currency trading

 

 

 

 

External Links:

 

Forex Education:

 

External Links for finding FX info

 

My favorite:  OANDA.com

 

Others:

  

 

External Links about Currency Trading

 

 

 

 

 

 

 

 

 

 

 

 

 

Books about FX trading from Amazon.com

 

 

 

 

 

 

 

 

 

 

 

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