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Introduction to Trading Forex |
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Foreign
Exchange
This
short introduction explains the basics of trading Forex online, a
brief explanation of the markets and the major benefits of trading
Forex online. There are also two scenarios
describing the implications of trading in a bear
as well as bull market to better acquaint you
with some of the risks and opportunities of the
largest and most liquid market in the world.
As an additional aid for those
who are new to Forex, there is also a glossary
at the bottom of this text which explains some of the terms used
in connection with currency trading.
Overview
Foreign
exchange, forex or
just FX are all terms used to describe the
trading of the world's many currencies. The forex
market is the largest market in the world, with trades
amounting to more than USD 1.5 trillion every day. This is more
than one hundred times the daily trading on the
NYSE (New York Stock Exchange). Most forex trading is
speculative, with only a few percent of market
activity representing governments' and companies' fundamental
currency conversion needs.
Unlike trading on the stock
market, the forex market is not conducted by a central exchange,
but on the “interbank” market, which is thought
of as an OTC (over the counter) market. Trading
takes place directly between the two counterparts necessary to
make a trade, whether over the telephone or on electronic networks
all over the world. The main centres for trading are Sydney,
Tokyo, London, Frankfurt and New York. This worldwide distribution
of trading centres means that the forex market is a 24-hour
market.
Trading
Forex
A currency trade is the
simultaneous buying of one currency and selling of another one.
The currency combination used in the trade is called a
cross (for example, the Euro/US Dollar, or the
GB Pound/Japanese Yen.). The most commonly traded currencies are
the so-called “majors” – EURUSD , USDJPY , USDCHF and GBPUSD .
The most important forex market
is the spot market as it has the largest volume. The market is
called the spot market because trades are
settled immediately, or “on the spot”. In practice this means two
banking days.
Forward
Outrights
For forward outrights, settlement on
the value date selected in the trade means that even though the
trade itself is carried out immediately, there is a small interest
rate calculation left. The interest rate differential doesn't
usually affect trade considerations unless you plan on holding a
position with a large differential for a long period of time. The
interest rate differential varies according to the cross you are
trading. On the USDCHF , for example, the interest rate
differential is quite small, whereas the differential on NOKJPY is
large. This is because if you trade e.g. NOKJPY, you get almost 7%
(annual) interest in Norway and close to 0% in Japan. So, if you
borrow money in Japan, to finance the trade and buying NOK, you
have a positive interest rate differential. This differential has
to be calculated and added to your account. You can have both a
positive and a negative interest rate differential, so it may work
for or against you when you make a trade.
Trading on Margin
Trading on margin means that you can buy and
sell assets that represent more value than the capital in your
account. Forex trading is usually conducted with relatively small
margin deposits. This is useful since it permits investors to
exploit currency exchange rate fluctuations
which tend to be very small. A margin of 1.0% means you can trade
up to USD 1,000,000 even though you only have $10,000 in your
account. A margin of 1% corresponds to a 100:1
leverage (or 'gearing'). (Because USD 10,000 is 1% of USD
1,000,000.) Using this much leverage enables you to make profits
very quickly, but there is also a greater risk of incurring large
losses and even being completely wiped out. Therefore, it is
inadvisable to maximise your leveraging as the risks can be very
high. For more information on the trading conditions of Saxo Bank,
go to the Account Summary on your SaxoTrader and open the section
entitled "Trading Conditions" found in the top right-hand corner
of the Account Summary.
Why trade Forex?
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24 hour trading
One of the major advantages of
trading forex is the opportunity to trade 24 hours a day from
Sunday evening (20:00 GMT) to Friday evening (22:00 GMT). This
gives you a unique opportunity to react instantly to breaking
news that is affecting the markets.
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Superior liquidity
The forex market is so liquid that
there are always buyers and sellers to trade with. The
liquidity of this market, especially that of
the major currencies, helps ensure price stability and narrow
spreads. The liquidity comes mainly from
banks that provide liquidity to investors, companies,
institutions and other currency market players.
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No commissions
The fact that forex is often
traded without commissions makes it very attractive as an
investment opportunity for investors who want to deal on a
frequent basis.
Trading the “majors” is also cheaper than trading other
cross because of the high level of liquidity.
For more information on the trading conditions of Saxo Bank, go
to the Account Summary on your SaxoTrader and open the section
entitled "Trading Conditions" found in the top right-hand corner
of the Account Summary.
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100:1 Leverage
Leverage (gearing) enables you to
hold a position worth up to 100 times more than your
margin deposit. For example, a USD 10,000 deposit can command
positions of up to USD 1,000,000 through leverage. You can
leverage the first USD 25,000 of your investment up to 100 times
and additional collateral up to 50 times.
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Profit potential in falling
markets
Since the market is constantly
moving, there are always trading opportunities, whether a
currency is strengthening or weakening in relation to another
currency. When you trade currencies, they literally work against
each other. If the EURUSD declines, for
example, it is because the U.S. dollar gets stronger against the
Euro and vice versa. So, if you think the EURUSD will decline
(that is, that the Euro will weaken versus the dollar), you
would sell EUR now and then later you buy Euro back at a lower
price and take your profits. The opposite trading scenario would
occur if the EURUSD appreciates.
Important
Forex Trading Terms
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Spread
The spread is
the difference between the price that you can sell currency at (
Bid) and the price you can buy currency at (
Ask). The spread on majors is usually 3 pips
under normal market conditions. For more information on the
trading conditions at Saxo Bank, go to the Account Summary on
your Client Station and open the section entitled "Trading
Conditions" found in the top right-hand corner of the Account
Summary.
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Pips
A pip is the smallest unit by
which a cross price quote changes. When trading forex you will
often hear that there is a 3-pip spread when
you trade the majors. This spread is revealed when you compare
the bid and the ask price, for example EURUSD
is quoted at a bid price of 0.9875 and an ask price of 0.9878.
The difference is USD 0.0003, which is equal to 3 “pips”.
On a contract or position, the value of a pip can easily be
calculated. You know that the EURUSD is quoted with four
decimals, so all you have to do is cancel out the four zeros on
the amount you trade and you will have the va value of one pip.
Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a
USDJPY 100,000 contract, one pip is equal to 1000 yen, because
USDJPY is quoted with only two decimals.
Trading
Scenario – Trading Rising Prices
If you believe that the Euro will
strengthen against the dollar you'll want to buy Euro now and sell
it back later at a higher price.
You buy Euro |
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We quote
EURUSD at Bid 0.9875
and Ask 0.9878, which means that you
can sell 1 Euro for 0.9875 USD or buy 1 Euro for 0.9878
USD .
In this example you buy Euro 100,000, at the quote
price of 0.9878 (ask price) per Euro. |
The market moves in your favor |
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Later the
market turns in favour of the Euro and the
EURUSD is now quoted at Bid 0.9894 and Ask 0.9896. |
Now you sell your Euro and get the profit |
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You sell Euro
at a Bid price of 0.9894. |
The profit is calculated as follows |
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Sell price-buy
price x size of trade
(0.9894 minus 0.9878) multiplied by 100.000 =
USD 140 Profit
(Note that the profit or loss is always expressed in the
secondary currency) |
Trading Scenario – Trading Falling
Prices
If, on the other hand, you believe
that the Euro will weaken against the dollar, you'll want to sell
EURUSD .
You sell Euro |
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We quote
EURUSD at a Bid price of
0.9875 and Ask price of 0.9880 and you
decide to sell Euro 100,000 at a
Bid price of 0.9875. |
The market moves in your favour |
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The Euro weakens against the
dollar and the EURUSD is now quoted at bid
0.9744 and ask 0.9749. |
Now you buy back your Euro |
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You buy EUR at an
ask price of 0.9749. |
Your Profit/loss is then |
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Sell price-buy price x size
of trade
(0.9875 minus 0.9749) multiplied by 100.000 = USD 1260 Profit
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Remember that trading EUR 100,000 as we have done in our examples,
does not mean that you have to put up Euro 100,000 yourself. On a
2% margin means that you have to deposit 2.0% of Euro 100,000,
which is Euro 2,000 on margin as a guarantee for the future
performance of your position.
Further
Reading
To see how you can trade the forex
market and benefit from our toolbox of information and live
quotes, please proceed to the Forex Quick Start found under the
Trading menu of SaxoTrader.
Glossary
Appreciation |
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An increase in
the value of a currency. |
Ask |
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The price requested by the
trader. This usually indicates the lowest price a seller will
accept. |
Base currency |
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The currency that the
investor buys or sells (i.e. EUR in EURUSD ). |
Bear |
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Someone who believes prices
are heading down. A bear market is one in which there is a
sustained fall in prices and which does not look like it will
recover quickly. |
Bid |
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The price offered by the
trader. This usually indicates the highest price a purchaser
will pay. |
Bid/Ask |
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The Bid rate is the rate at
which you can sell. The Ask (or offer) rate is the rate at
which you can buy. |
Bull |
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Someone who is optimistic
about the market. A bull market is characterised by
enthusiastic and sustained buying. |
cross |
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When trading with
currencies, the investor buys one currency with another. These
two currencies form the cross: for example, EURUSD . |
Cross rate |
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An exchange rate that is
calculated from two other exchange rates. |
Depreciation/decline
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A fall in the value of a
currency. |
Exchange rate |
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What one currency is worth
in terms of another, for example the Austrialian dollar might
be worth 58 US cents or 70 yen.
Currencies traded freely on foreign-exchange markets have a
spot rate (applying to trades settled 'spot', ie, two working
days hence) and a forward rate. Countries can determine their
exchange rates in a variety of ways.
1. A floating exchange rate system where the currency finds
its own level in the market.
2. A crawling or flexible peg system which is a combination of
an officially fixed rate and frequent small adjustments which
in theory work against a build-up of speculation about a
revaluation or devaluation.
3. A fixed exchange-rate system where the value of the
currency is set by the government and/or the central bank. |
EURUSD |
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Means that you trade EUR
against dollars. If you buy Euro you pay in dollars and if you
sell Euro you receive dollars. |
FX, Forex, Foreign Exchange
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All names for the
transaction of one currency for another, e.g. you buy £100.00
with USD 150.25 or sell USD 150.25 for £100.00. |
Interbank |
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Short-term (often overnight)
borrowing and lending between banks, as distinct from banks'
business with their corporate clients or other financial
institutions. |
Interest rate differential
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The yield spread between two
otherwise comparable debt instruments denominated in different
currencies. |
Leverage (gearing) |
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In this case leverage means
that the investor only funds part of the amount traded. |
Long |
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To buy. |
Long position |
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A position that increases
its value if market prices increase. |
Liquid (-ity) |
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The capacity to be converted
easily and with minimum loss into cash. A liquid market is one
in which there is enough activity to satisfy both buyers and
sellers. Ultra-short-dated treasury notes are an example of a
liquid investment. |
Margin |
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The deposit required when
entering into a position as well as to hold an open position.
Your margin status can be monitored in the Account Summary. |
NYSE |
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The New York Stock Exchange. |
Open position |
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A position in a currency
that has not yet been offset. For example, if you have bought
100,000 USDJPY , you have an open position in USDJPY until you
offset it by selling 100,000 USDJPY , thus "closing" the
position. |
“Over the counter” |
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When trading takes place
directly between two parties, rather than on an exchange. Over
the counter trades can be customised whereas exchange-traded
products are often standardised. |
Pips |
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A pip is the smallest unit
by which a Forex cross price quote changes. So if EURUSD bid
is now quoted at 0.9767 and it moves up 2 pips, it will be
quoted at 0.9769. |
Position |
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Traders talk of 'taking a
position' which simply means buying or selling currency cross.
'Position' can also refer to a trader's
cash/securities/currencies balance, whether he or she is short
of cash, has money to lend, is overbought or oversold in a
currency, etc. |
Risk |
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Trying to control outcomes
to a known or predictable range of gains or losses. Risk
management involves several steps which begin with a sound
understanding of one's business and the exposures or risks
that have to be covered to protect the value of that business.
Then an assessment should be made of the types of variables
that can affect the business and how best to protect against
unwelcome outcomes. Consideration must also be given to the
preferred risk profile - whether one is risk- averse or fairly
aggressive in approach. This also involves deciding which
instruments to use to manage risk, and whether a natural hedge
exists that can be used. Once undertaken, a risk-management
strategy should be continually assessed for effectiveness and
cost. |
Secondary currency (variable
currency or counter currency) |
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The currency that the
investor trades the base currency against (i.e. USD in EURUSD
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Short position |
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A position that benefits
from a decline in market prices. |
Short |
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To sell. |
Speculative |
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Buying and selling in the
hope of making a profit, rather than doing so for some
fundamental business-related need. |
Spot |
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A Spot rate is the current
market price of an asset. |
Spot market |
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The part of the market
calling for spot settlement of transactions. The precise
meaning of 'spot' will depend on local custom for a commodity,
security or currency. In the UK, US and Australian
foreign-exchange markets, 'spot' means delivery two working
days hence. |
Spread |
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The difference between the
bid and the ask rate. |
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