Welcome to the World of Forex Trading

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Forex is the largest market in the world. Forex traders exchange $4 trillion each day, but are forex the best market for you? The answer depends on what you are looking for. If you want a market that never sleeps, if you want the opportunity to trade at any time of the day, if you would like to make a boatload of money in a short amount of time, forex may be for you (it should be noted that you may also lose an incredible amount of money in a short amount of time).

What is Forex Trading?

The foreign exchange market is the “place” where currencies are traded. Currencies are important to most people around the world, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in Euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into Euros. The same goes for traveling. A French tourist in Egypt can’t pay in Euros to see the pyramids because it’s not the locally accepted currency. As such, the tourist has to exchange the Euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

“Forex” is simply an abbreviation for “foreign exchange.” All foreign exchange transactions involve two currencies.

The foreign exchange market most often called the forex market, or simply the FX market is the most traded financial market in the world.

The participants of the Forex market include banks, corporations, institutional investors, hedge funds and individuals. In simple terms Forex trading is where you can buy and sell currencies, simultaneously. The way it works is much like the process of currency exchange at airports or hotels where you can exchange the currency you deal with for the local currency.

The Forex market is open 24 hours a day 5 days a week, enabling traders to buy and sell around the clock acting on global news events as they happen.

How Currencies Are Traded ?

An example may be helpful to illustrate how currencies are traded. If you are a hotshot forex trader, and you believe that the EUR/USD is going to go up, you may decide to buy the EUR/USD. Thus, you think that the Euro currency will get stronger, and the U.S. dollar will weaken. You are buying the EUR/USD currency pair, another way to look at this is to say you are buying Euros and simultaneously selling U.S. dollars. The unique (and often difficult to understand) aspect of forex trading to keep in mind is this: Each forex transaction involves the buying of one currency pair and simultaneously the selling of another currency pair.

Liquidity

Liquidity refers to the level of market interest the level of buying and selling volume available at any given moment for a particular asset or security. The higher the liquidity, or the deeper the market, the faster and easier it is to buy or sell a security.

The Open Time of the Trading Week

There is no officially designated starting time to the trading day or week, but for all intents the market action kicks off when Wellington, New Zealand, the first financial center west of the international dateline, opens on Monday morning local time. Depending on whether daylight saving time is in effect in your own time zone, it roughly corresponds to early Sunday afternoon in North America, Sunday evening in Europe, and very early Monday morning in Asia.

The Sunday open represents the starting point where currency markets resume trading after the Friday close of trading in North America (5 p.m. Eastern time). This is the first chance for the forex market to react to news and events that may have happened over the weekend. Prices may have closed New York trading at one level, but depending on the circumstances, they may start trading at different levels at the Sunday open.

Forex Market Center Time Zone Opens Asia/Calcutta Closes
Asia/Calcutta
Frankfurt – Germany Europe/Berlin 12:30 PM 08:30 PM
London – Great Britain Europe/London 01:30 PM 09:30 PM
New York – United States America/New_York 06:30 PM 02:30 AM
Sydney – Austrailia Australia/Sydney 02:30 AM 10:30 AM
Tokyo – Japan Asia/Tokyo 04:30 AM 12:30 PM

What are Technical Indicators?

Indicators are simply another way of looking at a market price. In much the same way that it is possible to examine the speed of a car in many different ways, it is possible to examine price charts in many different ways, with indicators. Just for a moment, consider how many different ways you may measure the speed of a car:

  • Measured in kilometers per hour.
  • Measured in miles per hour.
  • Measured in the time it takes to travel one mile.
  • Measured by the time it takes to accelerate to 60 mph.
  • Measured by how quickly the car can stop.

Likewise, there are many ways to look at price on a chart. There are more technical indicators than telephone call centers in India.

Other Financial Markets

Some of the other key financial markets

  • Gold
  • Oil
  • Stocks
  • Bonds

Reading a Forex Quote

When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Euro (EUR), the forex quote would look like this:

EUR/USD = 1.1950

This is referred to as a currency pair. The currency to the left of the slash is the BASE currency, while the currency on the right is called the QUOTE or counter currency. The base currency (in this case, Euros) is always equal to one unit (in this case, Euro €1), and the quoted currency (in this case, the U.S. dollar) is what that one base unit is equivalent to in the other currency. The quote means that Euro €1 = 1.1950 U.S. dollar. In other words, Euro €1 can buy 1.1950 U.S. dollar.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either DIRECTLY or INDIRECTLY. A direct currency quote is simply a currency pair in which the domestic currency is the base currency (Direct); while an indirect quote, is a currency pair where the domestic currency is the quoted currency (Indirect).

So if you were looking at the Euros as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be EUR/USD, while an indirect quote would be USD/ EUR. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.

For example, if Euro is the domestic currency, a direct quote would be 1.1950 EUR/USD, which means with E€1, you can purchase US$1.1950. The indirect quote for this would be the inverse

Cross Currency

When a currency quote is given without the U.S. dollar as one of its components, this is called a CROSS currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY.

Bid and Ask

Bid Price (Buy). Buying means going long.
Ask Price (Sell). Selling means going short.
The bid price is used when selling a currency pair (going short).

Currency Quote Overview

USD/CAD = 1.2232/37

Base Currency : Currency to the left (USD)
Quote/Counter Currency : Currency to the right (CAD)
Bid Price : 1.2232
Price for which the market maker will buy the base currency. Bid is always smaller than ask.
Ask Price : 1.2237
Price for which the market maker will sell the base currency.
Pip : One point move, in USD/CAD it is .0001 and 1 point change would be from 1.2231 to 1.2232 The pip/point is the smallest movement a price can make.
Spread : Spread in this case is 5 pips/points; difference between bid and ask price (1.2237-1.2232).

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History of the Forex Market

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Foreign exchanges markets we first developed to facilitate cross border trade conducted in different currencies by government, companies and individuals. In the early days the foreign exchange markets primarily existed to facilitate the international movement of money, however even in the early days there were speculators.

These days a large portion of the Forex market is driven by speculation, arbitrage and professional dealing. In the past retail investors could only gain access to the foreign exchange market through banks that transact large amounts or currencies for commercial and investment purposes. Trading volume has increased rapidly over time, especially after exchange rates were allowed to float freely in 1971.

The 20th century saw the rise and fall of a number of economic agreements and exchange rate mechanisms, all of which were created with intention of promoting international economic stability and to provide an efficient and reliable means for valuing exchange rates. The most notable of these was the Bretton Woods agreement, stretching from 1944 to 1971.

The Bretton Woods agreement was born in 1944 at the conclusion of world war II with the intention of promoting international economic stability and freer trade, both were thought to be major causes of the war. It was created by John Maynard Keynes, the father of Keynesian economics, and Harry Dexter White. Its key points included:

  • The Creation of international authorities to promote international economic stability and free trade. This was the International Monetary Fund (IMF), World Bank and the general agreement on tariffs and trade (GATT).
  • The fixing of exchange rates for economies.
  • The convertibility between gold and the USD, empowering the USD as the worlds base currency.

This was the most powerful agreement affecting exchange rates over the 20th century, stretching 27 years and setting in place the role of the USD as the worlds base currency. Of the above key points, only the first is still in place today, with the IMF, World Bank and GATT continuing to play a key role in the international economy.

After the Bretton Woods agreement concluded in 1971, a number of policies were introduced that led to the eventual free market policies we have today. These free market policies have promoted floating exchange rates, deregulation of financial markets and trade liberalisation. All of which have led to changes in the function, size and complexity of global markets, the Forex market in particular. This deregulation of financial markets led to the creation of new financial products to facilitate the internationalisation of savings and investment, the effect of which was an increase in capital flows across borders from international investors (banks, funds, etc..) seeking to maximise their returns.

The deregulation of global financial markets and the free flow of capital across the world saw an unprecedented level of growth in the foreign exchange market. ‘Traditional’ turnover increased from approximately $5 billion USD a day in 1977 to over $600 billion USD a day in 1987. Over the period of 1988 to 1998 daily Forex turnover increased by a further 152%. This increase could be afforded to the above mentioned deregulation of global markets, as well as the increased speculative and hedging activities being undertaken by financial institutions and multinational corporations.

Throughout the 80s and 90s access to the Forex market was limited to banks, funds, commodity trading advisors (CTAs) managing large sums of money, large corporations and big investors. Access was afforded to this group as they were able to meet the strict credit guidelines established by banks that smaller investors were unable to meet.

As the Forex market grew, it gained increasing recognition as a means for individuals to speculate in global markets and in the early 2000’s the online Forex trading market was born. Online Forex brokers establish the ‘line of credit’ with a bank, otherwise known as a prime brokerage agreement. This negates the need for individuals to have the deep pockets previously required for individuals to trade in the Forex market.

It has gained significantly in popularity since the global financial crisis as investors seek ways to diversify their portfolios and generate returns not correlated with traditional markets such as equities and real estate. Investors are drawn to the high volatility of the Forex market, benefiting from the ability to go long or short, generating leveraged returns in rising and falling markets.

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Forex Market Basics

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How Does Forex Trading Work?

Forex trading is similar to trading share or futures except that when trading forex you are buying or selling one currency against another. One of the key advantage forex trading has over other financial instruments is that relatively small lot sizes can be traded, lot sizes can be as small as 1000 units or one micro lot. Typically forex trading also involves leverage which in some cases can be as high as 1:500, this is very different to trading shares where no leverage is involved. Leverage allows traders to trade with more money than they actually have in their trading account, For example if you had 1:100 leverage you could use a $1,000 deposit to control $100,000 worth of currency. Using leverage can result in an increase in you gains however if not used correctly if can also result in increased losses.

Forex Pricing

Every currency pair consists of a base currency and a term/quoted currency.

The first currency in the pair is the base currency, the second is the quote or term currency.

As an example with the EURUSD currency pair

EUR = Base currency

USD = Term currency

Bid: the rate at which you can sell the base currency. This is the first rate on the deal ticket below (1.34586).

Ask (or offer): The rate at which you can buy the base currency. This is the second rate on the deal ticket and can be found on the right (1.34588).

bid-ask

Spreads

The spread of a currency pair is the difference between the bid and the ask rate.

Pips

A pip represents the smallest increment that an exchange rate can move. One pip is 0.01 for currency pairs with JPY as the term currency and 0.0001 for all other pairs. Some brokers offers fractional pip pricing which represents a tenth of a pip. This is to improve the spread offered to clients and improve the precision with which they can trade.

Margins

Margin is the amount of money required in your account in order to open a position. Margin is calculated based on the current price of the base currency against USD, the size (volume) of the position and the leverage applied to your trading account. If you do not have sufficient free equity available you will be unable to open a position on the trading platform. The free margin amount shown in the trading platform is the amount you have available to use should you wish to open additional positions.

Margin is calculated using the following formula:

Margin required = (current market price x Volume) / Account leverage

In practice this would be calculated as follows:

If open a position of 0.1 (10000) in EUR/USD at the current market price of 1.35645 and your account has a leverage of 1:400 you would calculated the margin required as follows:

(1.35645 x 10000) / 400 = $33.91

In this example the margin on this position would be $33.91, therefore in order to open a positions of this size you would require at least $33.91 in free margin in your trading account.

Forex Trading Example

Selling EUR/USD

Opening the Position

The price of the EURO against the US Dollar (EUR/USD) is 1.33623/1.33624, you decide to sell 2 standard lots (the equivalent of €200,000) at 1.33623.

The value of your position is €200,000 x 1.33623 = USD $267,246. The leverage on your trading account is 1:100 therefore the margin required to open the position is USD $267,246 / 100 = USD $2,672.46.

Closing the Position

One week later the EURO has fallen against the US Dollar to 1.32128/1.32129, you decide to take your profit by buying back 2 standard lots at 1.32129.

The gross profit on your trade is calculated as follows:

Calculation
Opening Price €200,000 x 1.33623 = USD $267,246
Closing Price €200,000 x 1.32129 = USD $264,259
Gross Profit on Trade USD $ 2,988

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Common Order Types

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The three main types use in forex are stops, limits and market orders. Depending on whether you want to be a buyer or seller, above or below or at the market price will determine which of the below orders you should be using.

Stop buy buy order above the current market price

Limit sell sell order above the current market price

Market order buy or sell order at the current market price

Limit buy buy order below the current market price

Stop sell sell order below the current market price

Order-types1

Stop orders are commonly used for breakout and momentum style strategies. They buy in a rise market and sell and a falling market. Traders will often place these orders above resistance or below support, trading a break of these levels.

Limit orders are used by range and counter trend traders. Limit orders sell into a rising market and buy into a falling market. Because of this they are preferred by more experienced traders who are able to place these order types at key resistance and support levels, picking market swing points.

Market orders are orders to buy at the current ask (offer) rate or sell at the current bid rate.

Stop loss orders are orders to close a position at a predefined level set by the trader. This would normally be at a loss. These are technically stop buy and stop sell orders.

Take profit orders are orders to close a position at a predefined level, normally at a profit. These orders are limit orders.

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Forex Market Structure

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For most retail traders understanding the structure of the Forex market is something that is often overlooked. This is a critical element that needs to be considered when designing and implementing any trading plan. The forex market differs from other global markets due to the way it is structured. The main factors affecting the structure of the Forex market are the ways Forex products are traded, the participants and their motivation, regulation and the sheer size of the market. Since transactions in the Forex market are done over-the-counter (OTC) and not through a central exchange like futures or shares, prices behave differently. Understanding these differences is essential to your development as a forex trader and will only serve to help you in the future.

Over The Counter

The first thing to understand about the structure of the forex market is the way in which products are traded. Forex is for the most part, an over the counter (OTC) market. This means that there is no central exchange through which instruments are traded. When we refer to instruments, we are referring to the different forex products participants use to conduct transactions, whether they be corporate, speculative or hedging. These products include: Spot forex, outright forwards, forex swaps, forex options. When a product is traded OTC it is done so through a market maker. A market maker in forex is effectively a bank or broker that facilitates currency trades by providing buy and sell quotes and then taking orders. Orders can be hedged or passed on so there is no exposure/risk, matched within the internal order book or held by the market maker, meaning they take the other side of the order and take a position against the client.

Other commonly traded instruments such as shares and futures are exchange traded products, this means that any transaction involving these instruments is done through an exchange such as the New York Stock Exchange (NYSE) and London Stock Exchange (LSE). The points below highlight some features of OTC and exchange traded markets.

OTC

  • Market Made
  • Trading firm is the counterparty
  • Heavy price competition
  • Price and execution quality varies

Exchange Traded

  • Exchange is counterparty to all trades
  • Less price competition
  • Standardised price and execution
  • Regulatory oversight from exchange

Let’s expand on what OTC means in the case of the Forex market. Since there is no central exchange through which to process orders and transactions, a sophisticated network has been established in order to allow participants to communicate and transact. This network has different levels, each with its own institutions serving different functions within the forex market.

The interbank market is essentially a network between larger banks. This network is made possible through EBS (electronic broking services) and Reuters spot matching systems. These two applications effectively aggregate the order books of the banks, showing the various bids, offers and amounts that each is willing to transact at. This allows proper market function to occur by providing sufficient liquidity and efficient processing. The interbank market is only accessible to larger banks with the highest of credit standings, this is to eliminate any counterparty risk and reduce competition. By restricting access to the interbank market the big banks are continuing to maintain their share of forex turnover and thus profits.

The Players

At the top of the food chain we have the foreign exchange dealers. These are the dealer banks which conduct foreign exchange business for their clients or themselves. The major banks include; Deutsche Bank, UBS, Citigroup, Barclays Capital, RBS, Goldman Sachs, HSBC, Bank of America, JP Morgan, Credit Suisse and Morgan Stanley. These banks handle approximately 2/3 of the daily forex volume and along with others form what is known as the interbank market. These banks deal with each other on behalf of clients or for themselves, providing much needed liquidity to the market so large transactions whether corporate or speculative can be facilitated and proper market function can occur. The dealer banks that form the interbank market are effectively the market makers of the forex market, they set the prices and manage the volume for the rest of the market to feed off.

On the next level of the forex market we have the market that exists for financial and non-financial participants. This may include smaller banks, businesses, hedge/mutual/pension funds, CTAs and large investors. Traditionally the majority of foreign exchange turnover has been the result of international trade flows, this trend has changed in recent years with the majority of turnover being the result of capital flows, speculative and hedging activities. This shift reflects the increasing recognition of foreign exchange as a means of generating returns by all market participants, and the need to manage foreign exchange risks through hedging activities.

On the next level we have forex brokers and retail ECNs (electronic communications network). Traditionally forex brokers were the intermediary party between buyers and sellers, meaning they facilitated the transaction between the end user and their liquidity provider (market maker bank). For the most part this is still the case today, however, some brokers will run a book and trade against their clients. Brokers and ECNs will usually have an agreement with one or more liquidity providers, through which they can hedge positions on their book and manage any exposure they might have. A liquidity provider could be any one of the above mentioned major banks, or even another retail broker depending on their needs.

In the background of all this we have the central banks. The central banks follow their respective currency, making sure it’s price movements aren’t to erratic and promoting stability. They are participants in the market to diversify their currency reserves, influence the value of their exchange rate (less common nowadays) and make international payments on behalf of the government. To do all this the central bank has its own dealers who use a number of larger banks to help facilitate these flows of funds. Central bank intervention used to be far more common and have greater affect than it has nowadays. Rather than actively participating in the market buying and selling their currency, central banks instead use verbal intervention to affect the value of their currency.

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Spreads and Liquidity

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Spreads and liquidity go hand in hand as tight spreads are usually a result of good liquidity. We will be giving reference to the spread and liquidity of ECN environment to illustrate how this works.

What is a spread?

In the forex market the spread is the difference between the buy (bid) and the sell (ask/offer) price. The spread is a mechanism of the demand and supply in the market, or the prices at which participant are willing to transact.

The participants who are essentially liquidity providers include; banks, hedge funds, ECN’s and dark pools.

How is spread determined?

The spread with an ECN broker is made by aggregating our liquidity provider’s order books to show clients a best bid and best offer for each currency pair.

A liquidity provider’s order book will have volumes and rates they want to deal at. By combining these order books we are able to show very tight spreads and very deep liquidity. Deep liquidity refers to the large size and spread of orders for clients to execute their trades on.

In the screenshot below we can see the bids stacked up on the left side of the deal ticket and the offers stacked up on the right side of the deal ticket.

full-book-21

Every single bid in the left column represents a limit buy order from an Markets liquidity provider. The top bid price represents the highest price any of Markets liquidity providers are willing to pay. The number in the white box represents the volume they are offering at that price level, the number in the black box represents the aggregate volume available from that price level. As you move further down the bids you can see that the volumes increase significantly. The same applies for the offers on the right side of the deal ticket.

Summary

Liquidity is provided to the market through limit orders from liquidity providers. Aggregating the order books of liquidity providers ensures tight spreads and deep liquidity.

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Technical Analysis

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Overview

Technical analysis is essentially the study of price on charts in order to gain some insight into the past, present and future direction of price. It is a study that most traders use to make trading decisions, this adds to its significance and what makes it such an effective and reliable means of analysis.

Technical analysis works on the basis that everything that can affect the price of an instrument is already reflected in the price and thus on the chart. In the case of the forex market this means that all fundamental data, market sentiment, political factors, demand and supply are already reflected in the price of the currency. This is especially true in the case of the forex market since no one participant is able to manipulate the value of a currency due to the extreme size of the market.

Technical analysis also works on the basis that price or chart patterns repeat themselves. This is what makes it such a powerful tool. Since traders all around the world are watching the same chart, everyone is able to see the same patterns unfolding and act accordingly. Whether it be a trend following strategy, momentum or range trade, they all work on the premise that history repeats itself. This allows us to make informed trading decisions and create a system with an edge based on our own understanding of technical analysis.

Technical analysis primarily uses bar or candlestick charts to make trading decisions. Bar and candlestick charts show us the high, low, open and close over a particular time period. This tells us whether buyers or sellers were in control and provides us with insight as to who may be in control in the future.

The time frame of the chart you are studying determines the strength and significance of the analysis you are making. It will also be a determining factor as to how long you will be in a trade, your stop and take profit orders. Technical analysis done on a daily chart would likely result in a trade extending for days and weeks, where as a trade made off analysis done on a 5 minute chart would effectively be an intraday trade lasting minutes to hours.

Now lets explore some of the most popular types of technical analysis used by Forex traders.

Support and resistance

The most fundamental of ideas and the most important tool in any traders toolbox is by far support and resistance levels. They are such an effective means of analysing markets as almost every trader and market participant uses them to guide their decisions and thus respect these levels. This section will focus on the fixed price levels which we all know as the horizontal and trend lines that mark our charts, providing us with insight into the constant bull bear battle that is evident in the Forex market. Laying the foundation and understanding exactly what these levels mean will help to develop your perception of price, and provide you with highly probable areas for entry and exit of trades.

Support and resistance levels can be used to identify reaction levels or areas where we can expect the market to stall and or reverse, alternatively they can be used to form a bias regarding the future direction of price. They can mark swing points in price, areas of consolidation and define price ranges, all of which are covered in detail below.

Resistance

A resistance level is an area where sellers overcame buyers, resulting in the failure of price to move higher.

audusd-resistance-2-300x269

Support

A support level is an area where buyers overcame sellers, resulting in the failure of price to move lower.

support-300x230

Moving averages

Moving averages are an effective tool and have many different uses and applications. They can used to determine trends, both long and short term depending on the time frame. The can be used as floating support and resistance levels, determining a bullish or bearish bias, or providing entries and exits of trades.

Moving averages smooth the price data to form a trend following indicator. They do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices. Despite this lag, moving averages help smooth price action and filter out the noise. They also form the building blocks for many other technical indicators and overlays, such as Bollinger Bands, MACD and the McClellan Oscillator. The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).

 moving-averages-224x300

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