Chapter issue 1 - issue 14

Basics - psychology of price movement

The process by which the buyers believe prices are rising and sellers believe prices are falling is called “price discovery”. The result is trading at an equilibrium price. Once buyers and sellers make their trades, their impact on the market dissolves until they exit their respective positions. During a period of consolidation (narrow trading range), the longs and the shorts are sensitive to the first trade outside of this range. As price moves higher or lower, one group is increasing profit while the other group has increasing loss.

A trader’s reaction to price movement affects the three participants in every market situation and they all react to changing market prices differently:

• The longs - want higher prices
• The shorts- want lower prices
• Traders waiting to enter the market - traders on the sideline, waiting for further indication before entering

This last group of traders has the greatest potential impact, since they have not participated in the market to this point. Market bias changes as the market moves. A bullish trader may decide to go long on a “break-out” above the current trading range (conversely for a bear). These decisions by the “sideliners” have adverse effects on traders already holding a position in the market.

The effect our emotions have on price movement can be seen in the changing psychology of the market and all manifest themselves in a patterned movement:

• Fear
• Greed
• Frustration
  

Basics of FX - bid-offer spread

Foreign currency traders are considered to be dealers when they make a two-way market price, i.e. not just quoting one rate but two. A “bid” is a price at which a trader is willing to buy a currency and an “offer” is a price at which a trader is willing to sell a currency.

A sample of a two-way quote is:

• Eur/Usd 1.2145-1.2147
• Usd/Jpy 109.36-109.39
• Usd/Chf 1.2787-1.2790

The difference between the rate at which someone will buy a currency and the rate at which that person will sell is called the profit (spread). In the example above, a market maker will quote the bid of Usd/Jpy at 109.36 and will quote the offer at 109.39.

A “pip” is the term used to describe the fifth (last) digit in the exchange rate and is used to measure changes in the exchange rate. From the example above, if the Usd/Jpy rises to 109.40-109.43, then the Usd/Jpy has moved by 4 pips.

Basics of FX - brief history

The forex market has a long history, going back to the days of the barter system, with coins being in existence since ancient Egyptian times. To make commercial trading an easier process, currency notes were introduced in the Middle Ages. Right from their origins through to the end of the Second World War, these currency markets were relatively stable. All this changed as the post-war economies became extremely volatile, resulting in a dramatic increase in currency volatility, with the US Dollar taking its place and remaining as the benchmark ever since.

The Bretton Woods Accord, formed in 1944 between the US, UK and France as an attempt to stabilise the global economies, lasted only until early1970’s. More recently, the EMS, which was introduced in 1978 as an attempt to gain independence from the US Dollar, failed in a spectacular fashion in 1993, following the exit of the British Pound in 1992. Since then, the major global currencies have been freely trading with no structured boundaries.

Over the past 30 years or so, nations in the West have variously experienced currency devaluations, revaluations, the abandonment of the dollar-gold convertibility, oil crises, crises of confidence, exchange controls, snakes in tunnels, basket currencies, recycling pressure and the subsequent Third Worlds debtor nations’ crisis. However, on the whole, today we live in a world of freely floating exchange rates. There is a far better understanding of monetary economics on the part of the world’s governments, much reduced dependence on artificial trade barriers or exchange controls and a freedom and speed of international communication, which creates a single global foreign exchange market.

The most recent impact to the forex market occurred with the introduction of the Euro, which has risen in importance gaining its status as the second most liquid currency in the world. The result is that the major currencies now holding trading interest are the US Dollar, the Japanese Yen and the Euro, with as much as 90% of all transactions involving the US Dollar.

Basics of FX - characteristics

Characteristics - The foreign exchange market (also known as forex or fx market) is by far the largest market in the world, with an estimated $1.6 trillion average daily turnover. It is distinguished from the commodity or equity markets by having no fixed base or building, in that the forex market exists at the end of a telephone, the Internet or other means of instant communication.

This, it is viewed as being highly decentralized:- an over-the-counter (OTC), derivatives or interbank market. It is characterised by:

• An efficient market place
• 24/7 - in effect following the sun around the globe
• Super-liquidity unparalleled liquidity
• Minimal execution fees and high leverage
• A trending market some of the smoothest trends available
• Strategy fundamental or technical
  

Unlike other financial markets, investors in the forex market can respond to currency fluctuations caused by various factors, such as economic, social or political events, day or night.

Basics of FX - electronic FX trading

Not so long ago, banking institutions were the sole purveyors of the information vital to the transaction of business in the market. With no central organized market, bank traders executed trades solely by telephone or telex, writing trade details on pieces of paper, keeping positions on blotters and maintaining charts by hand. The resulting scarcity of information meant that price discovery was inefficient, bid-offer spreads were wide and margins were large. However, today most traders are quite sophisticated; they know where the market is and what bid-offer spreads to expect for the forex deals. Banks and brokers who are uncompetitive in their pricing don’t even leave the starting blocks.

What distinguishes the best from the rest are the provisions of:

• Online real-time automated dealing prices
• Competitive spreads
• Auto-fill ensuring transparency
• Online order function
• Free high-quality information - news, charts and analysis
• Real-time risk management systemscal
  

The electronic forex revolution is here and is providing traders of all sizes legitimate options for trading forex. It is now easier than ever and has the potential to revolutionize investment behaviour and provide more trading opportunities than ever before.

Basics of FX - fundamental analysis

The first factor to note about forex prices is that they are relative and not absolute. They represent, in the broadest sense, a comparison of economies and all that this entails, for example, unemployment and inflation.

Thus, fundamental approach relies on the analysis and understanding of several factors:

• Economic factors
• Social and political environment
• Government policy
• Monetary policy
• Fiscal policy

The above are all factual considerations and can be observed by reading any reputable financial journal. However, it is the subjective interpretation of these elements that makes a market and causes some of the violent gyrations.

The forex market is a dealing environment, where the participants, for the most part, have at their disposal all the tools and information technology they need to make money.

Thus, the following all play their part:

• Psychology
• Perceptions
• Expectations of future growth and political developments
• What others expect
• What has and has not been discounted
• Where the relative risks are or might be

All these factors are constantly looked at when trying to anticipate where the next pressure point will.

Basics of FX - long and short positions

In trading terminology, a “long” position is one in which a trader buys a currency at one price and aims to sell it later at a higher price (the sometimes elusive buy low, sell high strategy). In this scenario, the trader benefits from a rising market. A “short” position is one in which the trader sells a currency in anticipation that it will depreciate, i.e. fall. In this scenario, the trader benefits from a declining market. It is important to remember that every forex position involves being long in one currency and short in the other.

Basics of FX - margin / leverage

Margin is borrowing money to invest in the forex market. It is, in effect, a performance bond in cash or another means of collateral deposited by a trader. Investors generally use margin to increase their purchasing power to enable them to take larger positions in the market, without fully paying for it and maximizing their profits.

For example, a broker requires a client to open an account with $100,000, with an agreed margin level of 5%, allowing the client to trade with 20 times leverage (100 divided by 5), which also means the client needs to maintain 5% of any open position. Hence, the client can have open positions to the value of $2,000,000 ($100,000 divided by 5%). As profit or loses occur, the amount that can be traded varies accordingly.

So, if the client made a $20,000 profit one day, then the client could have an open position of $2,400,000 ($100,000 + $20,000 = $120,000 divided by 5%).

In general, brokers will require a margin to be deposited with the firm before trading can begin.

Obviously, in order to maintain a currency position, there must be sufficient funds to cover any potential loss:

• Initial margin represents the resources required to open a position.
• Variation margin represents the current profit or loss being made on any open positions.
• Maintenance margin is a minimum amount of collateral needed in the account.

Basics of FX - participants & roles

There are two roles played by the major participants in the forex market:

• Market makers - those people that both buy & sell currencies
• Price takers - those people seeking to either buy or sell currencies
  

The major participants in the market play a number of roles depending on their need for foreign exchange and the purpose of their activities. Historically, the forex market is called an interbank market due to the fact that banks, including central banks, commercial banks, and investment banks have dominated it. However, the percentage of other market participants has recently grown rapidly and now includes large multinational corporations, global money managers, registered dealers, international money brokers, asset managers, futures and options traders, and private speculators.

Basics of FX - price determinants

The laws of supply and demand drive exchange rates in the forex markets. The supply and demand for specific currencies change given the amount of trade and investment being done in that currency. If there is a high demand for a currency, its value increases. If there is a low demand then its value decreases. However, exchange rates are not only affected by supply and demand, but will also be influenced by the economic, political, monetary and social factors of the country/countries involved and also by outside developments. Exchange rates can change quickly and significantly, reflecting the volatility in the market. In addition, rumours and anticipated factors can also move rates. However, because of its size and volume, it is very difficult for any one entity to move the market for very long.

Basics of FX - psychology of trading

Successful traders always acknowledge the importance of psychology in their trading. Traders must be disciplined and remain emotionally detached from the market. Trading requires management of the emotional states. Emotional imbalance impairs the ability to make congruent decisions. The most optimal state is one of complete emotional detachment, to remain calm and to act in accordance with your strategy. That includes negative as much as positive emotions - the key word is to stay "cool".

Some of the most important points to remember are:

• Discipline
• Trade only what you can afford to lose
• Maintain mental clarity
• Trade with definite goals in mind
• Stick to your plan
• Let profits run
• Admit when you are wrong
• Watch carefully for market divergence
  

Basics of FX - technical analysis

This approach comprises of two basis elements:

• Charting involves the analysis of charts using various methods, for example moving averages, reversal formations, point and figure charts and trend line analysis.
• Technical analysis is the study and interpretation of price movements to determine future trends.
  A technician will assume that all fundamental factors are reflected in the price and that history tends to repeat itself. The tools used by a technician are charts, mathematical models and behavioural models.
  

In reality, fundamental analysis of forex rates is a good background study, but a poor trading tool. On the other hand, technical analysis is a tactical tool used by many in the market as the basis for position taking.

Basics of FX - trading costs

In any forex transaction, each party is both buying and selling, since it is buying one currency while selling another. One way of determining which is the buying rate and which is the selling rate, is to remember that a market maker will buy dollars for another currency at a low rate (its bid rate) and sell dollars for another currency at a high rate (its offered rate). From the example above, the following can be noted:
Market Maker
Sell francs
Buy dollars Buy francs
Sell dollars
1.2787 1.2790
Buy francs
Sell dollars Sell francs
Buy dollars
Market User
Because of this difference in whether you are a market maker or a market user, when traders take a position, they start with a small loss and thus need to gain some profit in order to at least break even. Thus, the spread is an automatic cost that the trader incurs when making the trade.

Basics of FX - widely traded currencies

The most commonly traded currency pair is EUR/USD. It accounts for about 30% of the global turnover. It is followed by USD/JPY, with about 20% and GBP/USD is the third major pair, with about 11%. The most often traded or 'liquid' currencies are those of countries with stable governments, respected central banks, and low inflation. Today, over 85% of all daily transactions involve trading of the major currencies.