Guide to Trading in FOREX
The Forex market is a massive market involving over $1trilion dollars traded every day, offering outstanding opportunities for the intrepid private investor.
By timing investments correctly, and by using the leveraged nature of Forex investments to one’s advantage, the private investor can enjoy substantial gains on the back of a relatively modest cash outlay. While Forex is huge, easily dwarfing other global markets such as equities and commodities, private investors make up a tiny proportion of this market.
This is because central bankers, commercial and investment banks, and hedge funds such as the Quantum fund, which is managed by George Soros, all speculate with billions of dollars on a regular basis.
The private investor, therefore, faces formidable competition and just as there are opportunities for substantial profits, losses can be equally dramatic.
Since all currencies are priced relative to each other, an increase in the value of one currency means that, by definition, another currency must have fallen in value. This makes the Forex market inherently more risky than other markets, which are expected to produce long term growth in value.The Forex market is also relatively new, only emerging after the collapse of the Bretton Woods system of fixed exchange rates in 1971.
According to the trade association, International Financial Services London, average daily global turnover in traditional foreign exchange market transactions totalled $2.7 trillion in April 2006. This ranks the Forex market at several times the size of the combined daily turnover of the world's equity markets.
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Opportunities for speculators and investors
At first glance, it may seem well nigh impossible for the small investor to make profits from Forex, when prices are dictated by trades between highly sophisticated investors.However, certain aspects of the market mean that it is sometimes imperfect at setting prices. Central banks, for example, don't typically speculate in the Forex market because their main objective is to support their own currency.
Sometimes, central banks try to manipulate currency prices by moving against the level markets would otherwise have dictated. If you believe that the price mechanism is king, that prices will always adjust to the market rate eventually and that manipulation of exchange rates by central banks is doomed to fail, then the private investor can enjoy profits simply by making logical choices based on fundamentals.
A classic example of this was when the Bank of England, tried to maintain the value of the pound against the German currency in 1992. The Chancellor of the Excheque at that time, Norman Lamont, tried to defy market forces, but on 16 September 1992 - a date now known as Black Wednesday - this policy unravelled, as speculators (like George Soros), who based their decisions on straightforward economic fundamentals, forced the ejection of sterling from the European Exchange Rate Mechanism.
The Forex market is also highly volatile, but with volatility comes opportunities for profit making. In the long term, underlying economic fundamentals determine the value of a currency.
The investor who has correctly evaluated these fundamentals can, therefore, use short term volatility to generate profits every time a currency deviates from its anticipated long term trajectory.
It's interesting to note, that in January 2007, the pound had recovered sufficiently from its ERM ejection 15 years earlier to be almost back at the same level as before Black Wednesday. The UK joined the ERM at 2.95 DM to the pound. When the euro was formed, the German currency was converted at a rate of 1.95583 DM to the euro. By January 2007, there were 1.5214 euros to the pound, which is the equivalent of 2.9756 of old DMs to the pound. So 15 years on from when George Soros made his fortune from dumping sterling, the pound had returned to its 1992 level.
The case above illustrates an important point. The investor who had correctly predicted the long term level of the pound against the Deutsch mark relative to the euro, could have enjoyed strong profits, just by using the short term volatility of the Forex market to buy and sell whenever its level deviated from the longterm trend.
There are four economic fundamentals in a local economy that help determine the value of the economy's local currency. These are:
- the rate of interest in the local economy relative to other economies;
- economic growth and projected growth measured by GDP;
- the budget surplus/deficit; and
- the balance of payments surplus/deficit
In the past, the balance of payments was considered to be the main factor determining a currency's strength over the longer term. But in recent years, this factor appears to have become less important.
For example, the US economy has suffered from a substantial balance of payments deficit for many years, and yet until the latter half of 2006, the dollar remained relatively strong.
In part, though, the strength of the dollar had been caused by the fact that many central banks hold the dollar as their main unit of foreign exchange. Therefore, domestic economic factors within the US were less significant.
The recent UK experience may be better for illustrating the apparent decline in importance of the balance of payments to a country’s currency.
The UK, like the US, has suffered from a substantial balance of payments deficit. But the combination of strong economic growth, and a high rate of interest, relative to most other major economies, has ensured that the pound has appreciated steadily over much of the first few years of this century against most other major currencies.
Conversely, Japan enjoyed a substantial balance of payments surplus, but the combination of a very low rate of interest, weak economic growth and high government borrowing meant the yen has depreciated.
In the short term, the rate of interest is thought to be the main factor influencing the value of a currency. If the rate of interest is high in one economy, then investors will want to enjoy the higher returns this higher rate of interest offers, and invest their funds in the economy with higher interest rates.
In recent years, the global economy has seen a phenomenon known as the ‘carry trade,’ in which money has been taken from Japan, where the rate of interest is low, and moved to countries where interest rates are much higher such as New Zealand, the US and the UK.
This has been a major factor behind the relative weakness of the yen, and the strength of the pound and dollar.
Unique characteristics of the Forex market
The Forex market has certain unique characteristics that the investor should be aware of:
- it is huge -typically experiencing trading volume in excess of $1 trillion ever day;
- it offers high liquidity to investors. Because of its size, liquidity in very strong, so in most cases speculators will have little difficult in buying or selling a currency;
- the market is open 24 hours a day Monday to Friday. For example, a speculator based in the UK can trade via markets in the Far East during the early hours of the morning, and via the North American markets in the evening;
- it is highly volatile;
- sophisticated tools are available to help you trade;
- a variety of investment options are available;
- investments are typically ‘margin’ type deals, meaning that the potential for losses and profits is multiplied several fold.
The investor or currency speculator has a variety of options for Forex dealing. These are:
Spot trading: where a currency is actually bought and cash settlement, on a margin basis, usually follows within 2 days. The spot market makes up 32 per cent of the Forex market
Forward: where an agreement is made to buy a currency at a future date
Swaps: where an agreement is made to swap an interest rate payment across one currency and switch back to the original currency at a future and defined date. This type of activity makes up 54 per cent of Forex trading
Options where an option confers on the holder the right to buy a currency at a future date, at a pre agreed price
Contracts for Difference where derivatives are settled on the basis of a currency's movement
Spread betting: a legally enforceable wager on the future price of a currency
Terms you should be familiar with
Interbank market: the method by which banks and hedge funds trade on the Forex market- it is by far and way the largest part of the market.
Retail market: the market place for private investors
International Standard Organisation (ISO): the code by which a currency is described, for example GBD - for sterling
Price notation: A currency is always valued relative to another currency - usually the dollar. The notation GBD/USD = 2.000, means there are two dollars for every unit of sterling
Majors and crosses: Pairings with the US dollar are known as the ‘majors.’ The ‘big four’ majors are: -
- EUR/USD: euro/US dollar
- GBP/USD: sterling/US dollar (known as “cable”)
- USD/JPY: US dollar /Japanese yen
- USD/CHF: US dollar/Swiss franc
Pairings of non-US dollar currencies are known as ‘crosses.’ We can calculate cross rates for GPB, EUR, JPY and CHF from the aforementioned major pairs. For example:
- EUR/JPY = (EUR/USD X USD/JPY)
Big figure, points or pips: a currency is usually represented by four digits after the decimal point - the main exception being the yen which is represented by two digits. The first two numbers after the decimal point are known as the ‘big figure.’ The second two figures after the decimal point are known as points or pips.
Long and short: a speculator who is said to have gone ‘long’ on a currency is buying that currency. A speculator who is said to have gone ‘short’ on a currency is selling that currency.
Margin: Investors are typically asked to pay between 1 and 5 per cent of a currency trade. If the currency then loses value, then the speculator maybe be asked to provide additional cash, to ensure the percentage margin is maintained.
Lots: A speculator will normally buy a currency in lots- typically 100,000 units. Some brokers offer mini lots.
Spread: There is no dealing charge as such in currency speculation, but the speculator will be quoted a spread. The spread is written in a particular format. For example, GBP/USD = 1.8000/05 means that the bid price of GBP is 1.8000 USD and the offer price is 1.8005 USD. The spread in this case is 5 ‘points.’
The larger the currency investor, the smaller the spread quoted. Thus banks and hedge funds have an inherent advantage over the private investor in that they can trade on much keener prices and enjoy profits on smaller fluctuations.
Buying and selling
Every purchase of the base currency implies a sale of the secondary currency, and every sale of the base currency implies the simultaneous purchase of the secondary currency.
For example, when you sell GBP/USD, you are selling GBP and buying USD. Similarly, when you buy GBP/USD you are buying GBP and simultaneously selling USD.
A private trader requires:
- a margin account broker with internet access;
- a computer terminal capable of running several programmes simultaneously;
- proprietary software to open and manage positions and to display technical analysis tools; and
- a sufficient number of monitors to trade, conduct technical analysis and manage the margin account.
Technical analysis is concerned with predicting future price trends from historical price and volume data. The underlying axiom of technical analysis is that all market fundamentals (including expectations) are reflected in exchange rates.
The art of technical analysis is the discernment of trends using tools such as:
- charts: line, bar and candlestick;
- support and resistance levels which reveal the historic upside and downside of the currency pair;
- channels and triangles, which plot the historic trading range of the currency pair, and flag up potential ‘breakouts;’
- indicators, which measure moving averages and momentum oscillators which purport to tell you where the weight of trading is taking the market to and when.