Lesson 1 - Basic concepts in trading

The stocks and foreign exchange markets are simply a place where currencies and stocks are traded.  Learning just a few trading techniques will improve your skills dramatically

Lesson 1 - Basic concepts in forex trading

The FX Market

The foreign exchange market, also known as forex or fx, is simply where currencies are traded. It’s the largest financial market in the world with an estimated six trillion dollars in daily trading volume. The forex market is decentralized, meaning that it doesn’t have a physical location nor a central exchange like for example the stock market and currencies are traded electronically “over-the-counter” via computer networks 24 hours a day, 5 days a week in the major financial centres in the world such as London, New York, Tokyo and Sydney. The exchange rate of a currency is generally determined by various macroeconomic factors such as monetary policy, fiscal policy and geopolitical events.

Currencies

There are various currencies you can trade and the most liquid (volume of activity) ones are those called “Majors” or “G8” representing the world’s most traded currencies and they are the USD (United States Dollar), the EUR (Eurozone Euro), the JPY (Japanese Yen), the GBP (Great British Pound), the CHF (Swiss Franc), the CAD (Canadian Dollar), the AUD (Australian Dollar) and the NZD (New Zealand Dollar). As you may have noticed currency symbols have three letters, the first two identify the country code and the third the currency’s name.

In forex you trade simultaneously one currency for another, as for any buyer there has to be a seller and vice versa. In fact, currencies are traded in pairs, such as the EUR/USD pair, through brokers or dealers. The exchange rates float constantly based on multiple factors. There are three major categories of currency pairs: the Majors, the Crosses and the Exotics.

The major currency pairs always include the USD (United States Dollar) paired to the other major currencies and they are the most traded and thus liquid ones having tight spreads and low commission costs.

The Crosses, also known as the Minors, are those pairs with the G8 currencies paired against one another excluding the dollar, like AUD/CAD, GBP/JPY, EUR/NZD and so on.

 

The Exotics are those pairs made up of one major currency paired against an emerging economy (EM) currency, such as Mexico, South Africa or Turkey. Depending on the liquidity of the pairs you will notice that the exotics, being the least traded ones, have bigger spreads and trading costs.

You may have noticed that the USD is frequently used and that’s because it’s the most traded currency in the world making up roughly 85% of all transactions. The USD comprises about 60% of the world’s foreign exchange reserves. There are some significant reasons why the U.S. dollar is so popular in the FX market and they are as follows: the United States economy is the largest in the world; the U.S. dollar is the reserve currency of the world; the United States has the largest and most liquid financial markets in the world; the United States has a stable political system; the United States is a military superpower; the U.S. dollar is the medium of exchange for many border transactions, for example, oil is priced in U.S. dollars, also called petrodollars. In the forex market most currency trading is based on speculation, estimated to be more than 90%.

 

Types of FX trading

There are different ways you can trade the FX market and they are Spot FX, FX Futures, FX Options and FX ETFs.

Futures are contracts to buy or sell a certain asset at a specified price on a future date, they are standardized and traded on a centralized exchange, like the Chicago Mercantile Exchange (CME).

An Option is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date. They are also traded on an exchange like the Futures, but the disadvantage is that market hours are limited for some options and liquidity is not at the levels of the Futures or Spot markets.

A currency ETF (Exchange-Traded Funds) allow people to invest in the forex market through a managed fund without the burdens of placing individual trades. They can be used to speculate, diversify a portfolio or hedge against currency risks. They are created and managed by financial institutions that buy and hold currencies in a fund and then offer shares of the fund to the public on an exchange allowing you to buy and trade these shares just like stocks.

The Spot FX market is an “over-the-counter” market running 24 hours a day without a central exchange. In an OTC market, a customer trades directly with a counterparty. Most of the trading is conducted through electronic trading networks (or telephone). The primary market for FX is the “inter-bank” market where banks trade with each other. The inter-bank market is only accessible to institutions that trade in large quantities and have a very high net worth, such as pension funds and large corporations or financial institutions.

In the Spot FX market, an institutional trader is buying and selling an agreement or contract to make or take delivery of a currency. Which means this spot contract is a binding obligation to buy or sell a certain amount of foreign currency at a price which is the “spot exchange rate” or the current exchange rate. So if you buy EUR/USD on the spot market, you are trading a contract that specifies that you will receive a certain amount of euros in exchange for U.S dollars at an agreed-upon price (or exchange rate).

It’s important to point out that you are not trading the underlying currencies themselves, but a contract involving the underlying currencies. Also note that even though it’s called “spot”, transactions aren’t exactly settled “on the spot”. In reality, while a spot FX trade is done at the current market rate, the actual transaction is not settled until two business days after the trade date. It means that delivery of what you buy or sell should be done within two working days and is referred to as the value date or delivery date.

 

There is a secondary OTC market that provides a way for retail traders to participate in the forex market. Access is granted by the so-called “forex brokers“. These brokers trade in the primary OTC market on your behalf. They find the best available prices and then add a “mark-up” in the exchange rate, which is their commission, before displaying the prices on their trading platforms. Although a spot forex contract normally requires delivery of currency within two days, in practice, nobody takes delivery of any currency in forex trading. The position is “rolled” over on the delivery date. Especially in the retail forex market. Remember, you are actually trading a contract to deliver the underlying currency, rather than the currency itself.

Retail forex brokers let you trade with leverage which is why you can open positions valued at fifty or hundred times the amount of the initial required margin (consider it a good faith deposit). To avoid this hassle of physical delivery, retail forex brokers automatically “roll” client positions. Retail forex transactions are closed out by entering into an equal but opposite transaction with your forex broker. For example, if you bought British pounds with U.S. dollars, you would close out the trade by selling British pounds for U.S. dollars. If you have a position left open at the close of the business day (end of the New York session), it will be automatically rolled over to the next value date to avoid the delivery of the currency. Your retail forex broker will automatically keep on rolling over your spot contract for you indefinitely until it is closed. When positions are rolled over, this results in either interest being paid or earned by the trader. These charges are known as a swap fee or rollover fee. Your forex broker calculates the fee for you and will either debit or credit your account balance.

Retail forex trading is considered speculative. This means traders are trying to speculate on the movement of exchange rates. They’re not looking to take physical possession of the currencies they buy or delivery the currencies they sell. The objective of forex trading is to exchange one currency for another in the expectations that the price will change and you profit from the difference.

Exchange rate

An exchange rate is simply the ratio of one currency valued against another currency, for example, the EUR/USD exchange rate indicates how many Euros can purchase one U.S. Dollar or how many U.S. Dollars you need to buy one Euro. Currencies are quoted in relation to other currencies and the currency on the left side is called the base currency while the currency on the right side is called the counter or quote currency.

 

When you buy a pair (or going long) you are doing so in expectation of the base currency to appreciate in value relative to the quote currency. When you sell the pair (or going short) you are doing it in expectation of the base currency to depreciate in value relative to the quote currency. The way that currency pairs are quoted in the forex market is standardized, so you will see the same quoting on all brokers. If you have no position in the market, then you are said to be flat. All pairs are quoted with two prices: the bid and the ask.

 

The bid is the price at which your broker is willing to buy the base currency in exchange for the quote currency, this means that the bid is the best available price at which you can sell to the market. If you want to sell something the broker will buy it from you at the bid price. The ask price is the price at which your broker will sell the base currency in exchange for the quote currency. This means the ask price is the best available price at which you can buy from the market. Another word for ask is the offer price. If you want to buy something, the broker will sell (or offer) it to you at the ask price. The difference between the bid and the ask is known as the spread.

Forex trading involves trying to predict which currency will rise or fall in value versus another currency. In forex you buy or sell in lots of 1,000 units (micro lot), 10,000 units (mini lot) or 100,000 units (standard lot). Forex trading is traded on margin. Margin trading lets you open large position sizes using only a fraction of the capital you would normally need to put down as good faith deposit. As previously stated, when you keep a position open overnight you will be charged or credited a rollover fee, also known as swap fee, usually at 5 p.m. EST depending on the position you have open. If you don’t want to earn or pay interest on your positions, simply make sure they are all closed before 5 p.m. EST, the established end of the market day. Since every currency trade involves borrowing one currency to buy another, interest rollover charges are part of forex trading. Interest is paid on the currency that is borrowed and earned on the one that is bought. If you buy a currency with a higher interest rate than the one you are borrowing, then the net interest rate differential will be positive and you will earn interest as a result. If it’s negative, then you will have to pay interest.

Retail forex brokers adjust their rollover rates based on different factors and you can check them with your broker for more information on their rates and procedures.

 

Pips and Pipettes

The unit of measurement to express the change in value between two currencies is called pip. A pip is usually the fourth decimal place of a price quote while on the yen pairs it’s the second decimal. There are forex brokers that quote pairs beyond the standard 4 and 2 decimal places to 5 and 3 decimal places. They are quoting fractional pips also called pipettes. The pip value depends on both the currency pair you are trading and the currency you funded your trading account with.

For example if you trade a pair with the US dollar on either side of the quote and your account is funded in Us dollars then the pip value will be 0.10$ if you trade a micro lot (0.01 lots or 1000 units), 1$ if you trade a mini lot (0.10 lots or 10.000 units) and 10$ if you trade a standard lot (1.00 lot or 100.000 units). Pip value matters because it affects your risk. Online you can find various forex position size calculators that do this automatically and later on you will see how to go through this process correctly.

Leverage and Margin

Leverage involves borrowing a certain amount of money needed to invest in something. In forex, you borrow money from your broker. Forex trading offers high leverage meaning that for an initial margin requirement a trader can control a big amount of money.

To calculate margin-based leverage, just divide the total transaction value by the amount of margin you are required to put up, for example, if you are required to deposit 1% of the total transaction value as margin and you want to trade one standard lot on EUR/USD pair, which is equivalent to 100,000 dollars, the margin required is 1,000 dollars. Thus, your margin-based leverage will be 100:1. For a margin requirement of just 0.25%, the margin-based leverage will be 400:1 using the same method. Margin-based leverage does not necessarily affect risk and whether a trader is required to put up 1% or 2% of the transaction value as margin may not influence his/her profit or loss.

The real leverage, not margin-based leverage, is the more accurate indicator of profit and loss. To calculate the real leverage you are currently using, simply divide the total face value of your open positions by your trading capital. For example, if you have 10,000 dollars in your account and you open a 100,000 dollars position (which is equivalent to one standard lot), you will be trading with 10 times leverage on your account (100,000/10,000). Note also that the margin-based leverage is equal to the maximum real leverage a trader can use.

A trader shouldn’t use all of the available margin. Once the amount of risk in terms of the number of pips of your stop loss is known, it is possible to determine the potential loss of capital (more on this later). Movements in FX pairs are just fractions of a cent. For example, when a currency pair like the EUR/USD moves 100 pips from 1.1800 to 1.1900, that is just a 1 cent move of the exchange rate, but a notable one in a day. This is exactly why currency transactions must be done in sizable amounts, transforming these little price movements into larger profits when magnified through the use of leverage.

This is why leverage is also called a double-edged sword since it has the potential to enlarge your profits, but also your losses by the same magnitude. Thus, the bigger the amount of leverage you use, the higher the risk you will assume. Leverage must be handled carefully, once you learn how to do this, you have no reason to worry. Small amounts of real leverage applied to each trade gives more breathing room to your trade by setting a wider but calculated stop loss. A highly leveraged trade can quickly wipe out your trading account if it goes against you.

Types of Orders

There are different types of orders that allow you to open positions in FX and they can be market orders or pending orders.

A market order instantly executes at the best available price at that moment. For example, if EUR/USD bid price is currently at 1.1000 and the ask price is at 1.1002 and you wanted to buy it now at market, then it would be sold to you at the price of 1.1002. Take note that depending on market conditions at the time there may be a difference between the price you selected and the final price your order is executed on your trading platform, for example during high volatile news events you may experience something called “slippage”, meaning that your order doesn’t get executed at the price you wanted but it slips to another best available price at that moment.

A limit order is an order placed to either buy below the market price or sell above the market price. So, it’s an order to buy or sell once the market reaches your chosen limit price level. You place a buy limit order to buy at a specified price below the current market price and a sell limit order to sell at a specified price above the current market price. You use this type of order when you believe the price will reverse upon hitting the price you specified. These orders are generally used to buy or sell on price retracements.

 

The stop entry orders are orders to buy above the market price or sell below the market price. You place a buy stop order to buy at a price above the current market price and it’s triggered when the market price touches or goes through the buy stop price. You place a sell stop order to sell at a price below the current market price and it’s triggered when the market price touches or goes through the sell stop order. These orders are generally used to buy or sell when the price breaches a certain level, so trading breakouts.

 

A stop loss order is the most important order of them all. It will close your position when the price reaches your specified level for a profit or a loss. So, if you are in a long position (buy order) it is a sell order and if you are in a short position (sell order) it’s a buy order. A stop loss order limits your risk! You should always have a stop loss order in place, not only to set correct position size for your trades but also to prevent further loss in the case your trading idea is wrong. A trailing stop is a type of stop loss order attached to a trade that moves automatically as the price fluctuates. So, if you set a 50 pips trailing stop and your position moves in your favour by 50 pips your trailing stop will move 50 pips too, but it won’t move back if the trade goes against you or it would be logically useless. You can also trail manually a stop loss, which is a more “safe” and professional way of doing it.  

FX Trading Sessions

Now let’s talk about forex trading sessions, because even if forex is open 24 hours a day doesn’t mean it’s seemingly active through all the hours. The forex market can be broken down into 3 major trading sessions: the Asian session (also called the Tokyo session), the European session (also called the London session) and the North American session (also called the New York session).

 

 

The trading week begins on Sunday night at 9 p.m. GMT, when the market opens, however, liquidity is very thin and starts to increase at the Tokyo session open at 12 a.m. GMT. Some characteristics of this session is that there are many notable countries present during this session including China, Australia, New Zealand and Russia. Liquidity can be thin and you will often see some kind of consolidation during this session if there’s nothing in the news feed to move it. If something big happens though during the Asian session, it may set the trend for the rest of the day as European session traders will look at what happened during the preceding session and trade accordingly. Logically the most moving currencies will be those related to the Asian session like the JPY, NZD and AUD since most of the news events during the session are related to those countries.

When the Asian session starts to come to the end, the European session begins. It’s the busiest session of them three and some characteristics include high liquidity and thus lower transaction costs, especially during the overlap with the North American session. If trends are established in the London session they may continue in the New York session.

At noon GMT the North American session begins. Some characteristics include high liquidity during the overlap with the London session. Most economic data are released near the start of the NY session and since about 80% of all trades involve the dollar they have the potential to move the markets. Once European session closes, liquidity starts to die down, especially on Friday afternoon as European traders prepare for the weekend and you can see profit taking moves not to be exposed to weekend risk. Note that usually the busiest days in the week are Tuesday, Wednesday and Thursday and the busiest sessions are the European and North American sessions with the busiest hours when the two sessions overlap.

FX Market Hierarchy

Finally let’s see how the Forex market is organised because even if it’s decentralized, it isn’t just chaos and randomness. You can sort it into a pyramidal structure: at the top there’s the interbank market composed of the largest banks in the world like Deutsche Bank, HSBC, JP Morgan and so on and some smaller banks, they trade directly with each other electronically, then you have the hedge funds, corporations, retail market makers and ECNs and at the bottom of the pile the retail traders.

 

Now that you know the basics of the FX market, let’s see the analysis you have to conduct before taking trades, how to manage your risk and how to keep going even when times are tough.

(Sources: investopedia, the balance, forexlive, google

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