Forex Education

Introduction to the Forex

Forex EducationForeign Exchange (also known as "Forex" or "FX") market is the place where currencies are traded. The overall forex market is the largest, most liquid market in the world with an average traded value that exceeds $2trillion per day and includes all of the currencies in the world.

There is no central marketplace for currency exchange, rather, trade is conducted over-the-counter. The Forex Market is open 24 hours a day, five days a week, with currencies being traded worldwide among the major financial centres of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - spanning most time zones.

The Modern Era in Foreign Exchange began to develop in 1971 with the advent of the Smithsonian Agreement. The Smithsonian Agreement ended the Fixed Exchange rate era established at the Bretton Woods Conference in 1944. The Bretton Woods Conference established an international fixed exchange rate regime in which currencies were pegged to the United States Dollar, which in turn was based on the Gold Standard.

By 1970 it was clear that the fixed rate regime was under threat, the USD was greatly overvalued due to heavy spending on President Lyndon B. Johnson's Great Society and the Vietnam War and all at a time when the US economy was under serious inflationary pressures.

In response, on August 15th, 1971 U.S. President Richard Nixon had the United States unilaterally devalue the dollar and entered negotiations with its industrialized allies to appreciate their currencies.

Meeting in December, 1971 at the Smithsonian Institute, the Group of Ten Industrialized Nations (G10) signed the Smithsonian Agreement in which the countries involved agreed to the US request to allow their currencies to appreciate against the USD. So ending the fixed exchange rate regime and replacing it with floating exchange rates or exchange rates that are free to be determined by market forces.

Since this time the Foreign Exchange market has developed into the world's largest financial market with daily turnover in excess of USD 2.0 trillion. Foreign Exchange trading is literally the exchanging of one country's currency for that of another. Unlike Stock Markets, Futures and some Options there is no regulated exchange, no clearing house or guarantee of trades and it is referred to as an Over The Counter or OTC market. It is therefore largely self regulated.

It is a true global market, that commences its week at 7am New Zealand time and remains open until 5.00pm Friday afternoon New York time.

Up until a short while ago large minimum transaction sizes and stringent financial requirements meant that only Banks, Hedge Funds, Major Currency Dealers, Government Agencies and the occasional high net worth individual were the principal participants. Now through the advent of the high speed internet trading platforms they provide Margin Foreign Exchange Trading to small, medium and large wholesale traders and investors. Providing real time quotes, news, charts and other information that has traditionally only been available to market professionals at large costs.

The Forex Market allows a trader to make profit when buying or selling. There is no commission per trade, but a spread between the buying and selling price. 


Advantages of Forex Trading

Compared to other financial markets, the forex market offers many advantages, such as 24 hour trading, no commissions and margin trading.

It is true that the forex market is open 24 hours a day, but that doesn’t mean that it is active during the whole 24 hours, and nor does it mean that you will want to trade at any time of the day or night.

To begin with, you can only make money when the market is moving. It doesn’t matter whether it moves up or down, but it has to be moving. You can’t make money when the market is sitting there doing nothing, and there are times when it does just that. So we need to take a look at the best times to trade.

First, we need to see what a 24 hour day appears like in the world of forex. There are four main trading sessions, the New York session, the London session, the Sydney session, and the Tokyo session. The actual opening and closing times of each session are similar to normal business hours in the city concerned. However, these will vary during April and October, because some countries change over to Daylight Saving Time in the spring, and back again in the fall. Furthermore, just to confuse things, spring and fall happen at different times in different parts of the world.

In between the forex trading sessions there are some times when two sessions are open at the same time and overlap. For instance, in both summer and winter, from 8.00 am – 12.00 pm ET, the New York session and London session overlap. In the summer, the London session and the Tokyo session overlap from 3.00 am – 4.00 am EDT.

Obviously, these times when two sessions overlap are the busiest, because when you have two sessions open at the same time you have much more trading going on.

Now another problem is the Sydney opening time. You are probably wondering why it is that it moves two hours. However, what happens here is that when America goes back an hour, Sydney actually moves forward one hour. That sounds crazy, until you remember that the seasons are the “wrong” way around here in Australia compared to America. When it’s spring in the US, its fall in Australia, and vice versa. Obviously, that has to be taken into consideration if you want to trade at those times.

Forex trading commission is free. This is in sharp contrast to what share and futures brokers offer. Majority FX brokers offers a forex trading with a 1% margin. In layman's terms that means a trader can control a position of a value of AUD 1 000 000 with a mere AUD 10 000 in his account. By comparison, futures margins are not only constantly changing but are also often quite sizeable.  


How does the Forex work?

The Forex Market allows you to buy and sell currencies against each other and speculate on the differences in exchange rates.

Making a transaction on the Forex Market is simple: the procedures are identical to that of any other market so switching to trading currencies is straightforward for most traders.

Engaging in Forex trading is actually very straightforward. When you place a trade in the Forex market, what you are actually dong is buying one currency and selling another. It is very much like other markets in the way that trade takes place, similar to the stock market for example.


Buying/Selling on the Forex Market

So what you are doing is exchanging one currency for another, hoping that the price will change, so that the currency that you buy will increase in value in relation to the one that you sold. (Or for that matter, the other way around).

Let’s take a simple example. Suppose you buy 5,000 GBP at a rate of 1.5624 GBP/USD rate. That means you have spent $7,812. After a week, the rate has changed, so you change your GBP back into US dollars at the new exchange rate of 1.6400, which is $8,200. You have just made a profit of $388 ($8,200 minus the $7,812 that you spent).

The exchange rate is just the rate at which one currency is valued against another. So, for instance, the USD/JPY exchange rate tells you how many Japanese yen you need to buy one dollar, or how many US dollars you need to purchase one Japanese yen.

When you trade Forex, you are always doing two things at the same time. You are buying one currency, and selling the other. Let’s look at this in a bit more detail.

Currencies are always quoted in pairs, so in the example above it would be GBP/USD. The currency on the left hand side is called the base currency, while the one on the other side is called the quote currency. The one on the right is also sometimes known as the counter currency. When you are buying, the exchange rate identifies how much of the quote currency you have to pay to buy one unit of the base currency. If you are selling, it works the other way around.

So in the example above, you have to pay 1.5624 USD to buy one GBP. If you are selling, you will see that you get 1.5624 USD for each GBP.

Whether you buy or sell will depend on what you think the market is going to do. If you believe that the base currency (the one on the left) will increase in value relative to the quote currency, you will buy the pair. If you think that it will lose value, you sell the pair. So, for instance, if we take GBP/JPY and you think that GBP will increase in value, you buy the pair, and if you think that GBP will go down – or lose value – relative to JPY you would sell the pair.

If you want to buy – remember, you are buying the base currency on the left – you want the base currency to go up in value, so that you then sell lit back at the higher rate. In the forex market, this is known as “going long” If you want to sell, you hope that the base currency will depreciate in value against the quote currency so that you can buy it back at a lower price. This is known as going short.

It’s not too difficult, if you just remember that “long” means buy, and “short” means sell.

The next thing to note is that Forex has two prices quoted. One is the bid price and the other is the ask price. The bid price is the price that your broker will pay you to buy the base currency while he sells you the quote one. That is the best price that you can sell into the market.

The ask price (also known as the offer price) is the price that your broker will sell you the base currency in exchange for the quote currency he is buying.

The difference between the two prices is known as the spread, which is where the broker makes his money.

If you want to open a position (eg place an order to sell - to make a profit if the exchange rate falls) you have to choose the amount (eg 100.000 AUDUSD) from the drop down menu on the platform and then click the mouse on the sell currency button: SELL. If you want to place an order to buy, you should act in reverse.

This will open a position in the market and you will receive an immediate notification of it on your trading platform. To close an open position, you have to do the opposite of the initial operation, in our case buy the 100.000 AUDUSD back.

Different order types also exist to open or close a position under a certain condition.

As with any market, for each currency pair, there are 2 prices. The difference between them is called the spread. The spread is measured in points or pips - lowest decimal figure in a currency rate.

For a AUDUSD a pip equals 0.0001 (or 10 dollars on 100.000), for EURJPY a pip equals 0.01 (or 1000 yen on 100.000).

Currencies are quoted in pairs, for example - AUD/USD or USD/JPY.

The first currency in the pair is called the base currency and the second is called the counter currency. The base currency is the 'basis' for purchases and sales. For example, if you buy AUD/USD, then you acquire Australian Dollars and sell American Dollars. You do this if you expect the Australian Dollar to grow against the American Dollar.

It is also possible for a currency pair to be quoted as USD/AUD, but this method is used extremely rarely.

Each transaction must have 2 sides - a buy and a sell (or a sell and a buy). By this we mean that it is impossible to buy 100.000 AUD/USD and then exchange it for another currency pair (eg AUD/JPY) without closing the first position.

Also please note that no physical currency delivery will be made.


Forex Margins

OK, so you don’t have enough money to buy 25,000 Australian Dollars. You can still enter a trade by borrowing the money that you need. As we have already seen, you can buy 25,000 AUD when you only have $500.

Sit quietly while we explain this.

When you go to Kmart, Woolworths or Coles, you can’t buy one AA battery. They come in packs of four, ten, or more. It’s the same thing with Forex. There is not much point in buying one AUD, so you buy in lots.

Let’s say you open with a standard lot, which is 100,000 units of AUD/USD. (There are standard lots, and there are also mini – and even micro – lots). You think that the AUD will increase in value against the USD. You buy with the AUD at a margin of, say, 2%. Let’s say that one lot of 100,000 units is at a price of 1.50000 to make things easy. This means that you are buying 100,000 AUD which are actually worth 150,000 USD. Two percent of 150,000 is 3,000. So if the margin is 2%, you need $3,000 in your account set aside in order to open the trade.

You now “own” 100,000 AUD, but all you needed was $3,000. If your thinking was correct, you may decide that the time has come to sell when the AUD gets up to 1.50750. You sell at that price, and you have earned $750. At this point, your original deposit is returned, and your profit (or loss) is credited or debited to your account.

Can you begin to see how this works? You can buy and sell Forex with minimal deposits, in relation to the amount of currency over which you have control. Of course, in order to make a profit, you have to get it right, but we will talk about that later on.

Let’s now talk about rollover.

If your position is still open at the end of the trading day, you can either earn or pay rollover interest on that position. So in other words, if you have not closed a position before the accepted closing time of the market, which is 5.00 pm EST, you may either earn or pay interest.

Every trade involves borrowing one currency so that you can buy another one. Interest rollover charges are simply a part of the game. If you don’t want to be a part of that game, it’s simple. Just make sure that you close all your trades before 5.00 pm EST.

The effect is straightforward. If you buy a currency that has a higher interest rate than the one that you are borrowing, you will actually earn interest as a result. Of course, it works the other way around, too. If the currency you are buying has a lower interest rate, you will be charged interest.

The actual rollover rates calculated by different brokers can vary according to a number of different factors. These can be things such as interbank lending rates, leverage, and more. You need to ask your broker for specifics on rollover interest rates.


Pips

No, it is not the seed of an apple or a strawberry. (Well, it is, but not as far as Forex is concerned). You need to understand pips, pipettes, and lots, before you even begin to start trading Forex. If you don’t “get” this you could lose money, and the object of trading Forex is to make money, not lose it. Any fool can lose money. Fortunately, the converse is not true. You don’t need to be a genius to make money, but you do need to have a clear understanding of how the market works.

Pay attention to what follows, as it can make all the difference.

So What is A Pip?

It is a unit of measurement that defines the change of value in two different currencies. If, for instance, the AUD/USD moves from 0.7605 to 0.7606, the increase is known as one pip. It is normally the last decimal place of any quotation, which is usually to four decimal places. (There are one or two exceptions: Japanese yen pairs only go to two decimal places).

However some brokers quote currency pairs that are in three or five decimal places. If, for instance, your broker quotes 0.76053 and it moves to 0.76054, the extra 0.00001 decimal place is called a pipette.

Each currency has its’ own relative value, so you need to work out the value of a pip for that particular pair. This can get really complicated, so the good news is that most Forex brokers will do the math for you.

As each currency has its own relative value, it’s necessary to calculate the value of a pip for that particular currency pair. In the following example, we will use a quote with 4 decimal places. For the purpose of explaining the calculations, the exchange rates will be expressed as a ratio (e.g. EUR/USD at 1.2500 will be written as “1 EUR/1.2500 USD”)

Example exchange rate ratio: USD/CAD = 1.0200.

(The value change in quote currency) times the exchange rate ratio is the pip value (in terms of the base currency)

[.0001 CAD] x [1 USD/1.0200 CAD]

Put more simply it means this:

[(.0001 CAD) / (1.0200 CAD)] x 1 USD = 0.00009804 USD per unit traded. Easy, yes?

Using this example, if we traded 10,000 units of USD/CAD, then a one pip change in the exchange rate would be approximately a 0.98 USD change in the value of the position (10,000 units x 0.0000984 USD/unit). (We have to say “approximately” because when the exchange rate changes, the value of the movement of each pip also changes).

The other problem is to ascertain the pip value in relation to your account currency. Obviously, not everyone is using the same currency for his or her trades, so the value of a pip needs to be transferred to the currency that we trade in. It makes sense.

This one is not too difficult. All you need to do is to multiply or divide the pip value that you have ascertained by the exchange rate of your currency, and the currency with which you are dealing.

For instance, if we have a pip value of 0.813 GBP/JPY and we need to convert that to USD, and the exchange rate ratio is 1.5604, it’s a simple matter of multiplying 1.5604 by 0.813 which gives us 1.2686 per movement of a pip.

What that means in English is that for every pip move in a 50,000 unit position, for instance, the value changes by approximately 6.35 USD.

Taking the earlier calculation of USD/CAD, if we need to work out the value of a pip of 0.98 USD in GBP and using 1.5604 as our exchange rate ratio we simply multiply 0.98 by 1.5604 and find that our pip move changes by about 7.65 GBP on our 50,000 unit position.

We bet you’re pleased that you now know all that. However, as we said earlier, this is something that most brokers will calculate for you, but you just need to know what they are doing.

Of course, these amounts of money are fairly insignificant on the face of it, but they can add up considerably, as we shall see.


What is a Lot?

Forex EducationA "lot" is simply a collection of units. You know that a pip is a very tiny percentage of the value of any given currency relative to another one, so it follows that in order to make any serious money, you will need to trade a lot of units.

In fact, Forex used to be traded only in specific lots, and a standard sized lot was 100,000 units. There are smaller lots of 10,000 units, 1,000 units, and 100 units, which are called mini, micro and nano respectively.

If we assume a 100,000 standard sized lot, let’s have a look at what happens to the value of a pip.

Take the USD/GBP at the exchange rate of 1.5654. This is .0001 divided by 1.5654 x 100,000 which is $6.38 per pip.

If the USD is not the first quoted currency, then a slightly different formula is used.

GBP/USD at the same rate as above. This is .0001 divided by 1.5654 x 100,000 = 6.38 x 1.5654 = 9.98725, which is rounded up to $9.99 per pip.

Just to confuse matters, different brokers have different methods of calculating the value of a pip in relation to the lot size, but there is no need to worry, since they will tell you the pip value for the currency you are trading.

Next question is: what is leverage? When you are a small trader, you don’t have tons of money to play with. You don’t have $100,000 (yet) so what happens is that your broker lends you the money with which to trade. Suppose he gives you $100,000. All he wants is a deposit of $1,000 which he holds for you. How much he is prepared to lend you depends on the individual broker.

As soon as you have made your deposit (known as an initial margin)you can begin to trade. If the broker is allowing leverage of 500:1 and you want to trade with $50,000, you only need $100 deposit. That is your initial margin, and your broker lends you the rest. Profits and losses are added to or deducted from your account balance. Of course, each broker is different, and will require different margins and offer different leverage.

So how do you work out your profit or loss on a trade? Let’s work on USD/GBP again, and assume that the rates you are quoted are 1.5705 / 1.5710. Since you are buying, you have to buy at the ask rate of 1.5710, and you buy 100,000 units at that rate, Before 5.00 pm EST the price has gone to 1.5730 so you decide to close the trade. The price is now 1.5730 / 1.5735. you are now selling, so you have to take the broker’s bid price of 1.5730. The difference between what you bought at and what you sell at is 20 pips.

So your profit works out as follows: .0001/1.5730 x 100,000 =$6.35 per pip. Multiplied by 20 pips, you have just made a profit of $127.00.

Not too bad for five minutes “work”.


Major Currencies

These are the eight currencies that are traded most often.

As follows they are:

  • USD – US dollar
  • GBP – British pound
  • JPY – Japanese yen
  • EUR – Euro
  • AUD – Australian dollar
  • NZD – New Zealand dollar
  • CHF – Swiss franc
  • CAD – Canadian dollar.

Every other currency pair is called a minor currency.


Bid Price

Quite simply, the price which your broker is prepared to pay you for a certain currency pair. As a trader you can sell the base currency, which is the currency shown on the left hand side of the quotation. For instance in the quote of CAD/USD of 0.8133/37, the bid price is 0.8133, which means that for every Canadian dollar you sell, you will get 0.8133 US dollars.


Ask Price

The Ask (or Offer) price is how much you have to pay for a certain currency pair. So, using the above pair as an example, the ask price is 0.8137 USD. That means that for every Canadian dollar that you want to buy, you will pay 0.8137 US dollars.


Bid/Ask Spread

The bid/ask spread is also how much it costs you for what is known as a round-turn trade. Simply put, it means a buy trade and a sell trade of the same amount in the same currency pair. Or the other way around: a sell trade of one and a buy trade of the other. So, for instance, if the EUR/GPB rate is expressed as 0.7095/0.7099, or for short 0.7095/99, then the cost of the transaction, or spread, is four pips.

The calculation is simply as follows: Ask Price – Bid Price – Transaction cost, or spread.


Base Currency

This is simply the first currency in any pair. What it does is show you how much the base currency is worth in relation to the other one of the pair. So, for instance, if the GBP/USD rate is 1.5628, then one GBP is worth 1.5628 USD.

Most of the time, the USD is regarded as the base currency for a quote, which means that most quotes are expressed as a unit of 1 USD in relation to the other currency in the pair. However, there are exceptions to the rule (you might have guessed!) and these are the euro, the British pound, and the New Zealand and Australian dollars.


Quote Currency

This is, quite simply, the second currency in any pair. It’s often referred to as the pip currency.


Cross Currency

This is any currency pair in which one of the currencies is NOT the USD. Strangely enough, when you trade in cross currencies, you are actually starting TWO trades. For instance, if you issued a long, or buy, order on EUR/GBP, you are buying a EUR/USD pair and selling a GBP/USD pair. There can be a considerably higher spread on cross currency pairs.


Pip

This is the tiniest unit of price for a currency. Most currencies are in five digits, with the majority having a decimal point after the first digit. So, for example, if GBP/USD is 0.7356, one pip change would mean that it would be 0.7355 or 0.7357, so a pip is the smallest change in the last digit which is 0.0001

However, if one of the pairs is JPY, then the pip is equal to 0.01, and not 0.0001.


Pipette

A pipette is simply one tenth of a pip. In order to clarify this, and taking into consideration that some brokers do quote pipettes in order to achieve extreme accuracy, then if the USD/GBP went from 1.56412 to 1.56409 it has moved by three pipettes.


Leverage

This is just a matter of how much money you can spend on a trade compared to the amount of your deposit. It can vary considerably, depending on your broker. It could be as little as 2:1 or as much as 500:1. If it was 500:1, you could trade a $25,000 mini lot with a deposit of just $50.


Margin

This is the amount of money that you must deposit with your broker in order to commence trading. It can be as low as $25, or as much as $100,000, depending on the broker.

Every time you open a new trade, a percentage of the money in your trading account is set aside in case of losses on the trade. This will depend on the currency pair, its’ present price, and the number of lots you want to trade. The size of the lot will always refer to the base currency.


How to start trading forex?

Open a live account if you feel ready to trade in the real market

OR

Open a demo account on one or both of our trading platforms and choose which suits you best

  1. Define how long you can trade for
  2. Define the currency pair you feel most comfortable with
  3. Choose the tradable amount
  4. Before opening a position, you have to consider how much profit you wish to make or how much loss you are eventually prepared to take. Depending on this analysis, place stop and/or limit orders
  5. Open your position or place an entry order
  6. Follow significant news events and technical indicators which you can consult inside your trading station or from third party sources

Different types of Brokers

Forex EducationYou may not want to know it, but there are different types of Forex Brokers. Chief among these are Dealing Desk brokers (DD) and No Dealing Desk brokers (NDD). Of course, you are probably wondering how you can deal if they do not have a dealing desk, but stick around and we’ll explain.

Dealing Desk brokers are also known as Market Makers. Meanwhile, No Dealing Desk brokers can be further divided into STP (Straight Through Processing) and ECN+STP – Electronic Communication Network + Straight Through Processing. Don’t worry: all will become clear.

Dealing Desk brokers make their money through spreads, and also providing liquidity to their clients. They are also known as Market Makers, since they quite literally create a market for their clients, often taking the other side of the client’s trade. They offer both a buy and sell quote, so they fill both the buy and sell orders of the client.

Market Makers control the prices at which they will fill the orders, so they can also set fixed spreads with very little risk to themselves. This is a benefit to you as a trader, which we’ll explain later.

As a client of a DD broker, you won’t be shown the actual interbank market rates, but this is not a problem, since the competition between individual brokers is fierce, and you will find that the rates offered are very close to – if not the same as – the interbank rates.

Let’s take a look at an example. Suppose you want to buy a standard lot of 100,000 units of GBP/USD. Your broker will first try to find one of its’ other clients who has a sell order of the same size. If they cannot do that, they will pass your order on to their liquidity provider. This way, they minimize their risk since they earn from the spread without having to make the other side of your trade themselves.

However, if they cannot find any matching orders, they have to take the other side of your trade. Each broker will have different policies regarding risk management – which they obviously want to minimize as far as they are concerned – so you need to check exactly what these are.

So what is a No Dealing Desk broker? Basically, what they are doing is connecting two entities, you and a trader who is offering the opposite side of the trade that you wish to place. They earn money by gaining a mark-up by increasing the spread a little, or by charging a small commission. NDD brokers can be either STP or STP+ECN brokers.

What’s the Difference?

A Straight Through Processing broker will direct your order straight to their liquidity provider who will be able to access the interbank market. Most NDD STP brokers have a large number of liquidity providers, each of which will have its own bid/ask rate.

As an example, let’s say that the bid and ask prices of different liquidity providers are as follows.

First liquidity provider has a bid price of 1.4540 and ask of 1.4543

Next liquidity provider shows a bid price of 1.4541 and ask of 1.4543

Third liquidity provider has a bid price of 1.4542 and ask of 1.4544

Your broker’s system will then sort these out into the best and worst bid and ask quotes. In this example, the best bid quote is 1.5642, because you want to sell at the highest price, and the best ask price is1.5643, because you want to buy for as little as possible.

Once your broker’s system has sorted this out, your bid/ask is now 1.4542/1.4543.

Is this the Price That You Will See on Your Platform?

No, don’t be silly. Your broker wants a cut on this deal as well, so what usually happens is that he will add a small mark-up. Let’s say this is 1 pip. What you will be quoted is 1.5641/1.5644. Although the best spread is only 1 pip, it becomes a 3 pip spread for you.

When you say that you want to buy a standard lot of 100,000 units of GBP/USD at 1.5644, your order goes to either the first or second liquidity provider each of which has a short position of 1.5643, while you have a long position of 1.5644. So your broker has earned 1 pip on the deal.

Because the bid/ask quotes are variable, this is also the reason why your broker probably has variable spreads. When the spreads of their liquidity providers widen, they have to widen theirs as well. Certainly, there are some brokers who do offer fixed spreads, but most of them do not.

So then, what is an ECN broker? An ECN broker (Electronic Communication Network broker) lets the client’s order interact with the other participants in the ECN. These could be various banks, hedge funds, other retail traders, or even other brokers. To put it at its’ simplest, all participants are trading against each other, quoting their best bid/ask prices. Furthermore, ECN’s also let you see the “Depth of Market”. This lets you see the buy and sell orders of the other participants. It also makes it difficult for ECN brokers to charge a fixed mark-up, so most of them will charge a small commission on the transaction.


FX Technical vs FX Fundamental Analysis

Forex technical analysis is a method of predicting price movements and future market trends by studying charts of past market action which take into account price of instruments, volume of trading and, where applicable, open interest in the instruments.

Forex fundamental analysis is a method of forecasting the future price movements of a financial instrument based on economic, political, environmental and other relevant factors and statistics that will affect the basic supply and demand of whatever underlies the financial instrument.

In practice, many market players use technical analysis in conjunction with fundamental analysis to determine their forex trading strategy. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments, whereas the fundamental analyst needs to know a particular market intimately. 


Forex Fundamental Analysis

Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analysing economic indicators, government policy and societal factors (to name just a few elements) within a business cycle framework. If you think of the financial markets as a big clock, the fundamentals are the gears and springs that move the hands around the face. Anyone walking down the street can look at this clock and tell you what time it is now, but the fundamentalist can tell you how it came to be this time and more importantly, what time (or more precisely, what price) it will be in the future.

There is a tendency to pigeonhole traders into two distinct schools of market analysis - fundamental and technical. Indeed, the first question posed to you after you tell someone that you are a trader is generally "Are you a technician or a fundamentalist?" The reality is that it has become increasingly difficult to be a purist of either persuasion. Fundamentalists need to keep an eye on the various signals derived from the price action on charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or the myriad of societal issues that influence prices.

Bearing in mind that the financial underpinnings of any country, trading bloc or multinational industry takes into account many factors, including social, political and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. At the same time, you'll find that your knowledge and understanding of a dynamic global market will increase immeasurably as you delve further and further into the complexities and subtleties of the fundamentals of the markets.

Fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analysing an economist's forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you'll need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy.

A trader who studies the markets using fundamental analysis will generally create models to formulate a trading strategy. These models typically utilize a host of empirical data and attempt to forecast market behaviour and estimate future values or prices by using past values of core economic indicators. This information is then used to derive specific trades that best exploit this information.

Forecasting models are as numerous and varied as the traders and market buffs that create them. Two people can look at the exact same data and come up with two completely different conclusions about how the market will be influenced by it. Therefore is it important that before casting yourself into a particular mold regarding any aspect of market analysis, you study the fundamentals and see how they best fit your trading style and expectations.

Don't succumb to 'paralysis by analysis'. Given the multitude of factors that fall under the heading of "The Fundamentals," there is a distinct danger of information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. This is one of the reasons why many traders turn to technical analysis. To some, technical analysis is seen as a way to transform all of the fundamental factors that influence the markets into one simple tool, prices. However, trading a particular market without knowing a great deal about the exact nature of its underlying elements is like fishing without bait. You might get lucky and snare a few on occasion but it's not the best approach over the long haul.

For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviours and unforeseen events. Therefore, it is best to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all 'The Fundamentals'.


Economic Indicators

Economic indicators are snippets of financial and economic data published by various agencies of the government or private sector. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, they are religiously followed by almost everyone in the financial markets. With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyse and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize and make trading decisions based on the data.

Keeping track of the calendar of economic indicators will help you make sense out of otherwise unanticipated price action in the market.

Consider this scenario: it's Monday morning and the AUD has been in a tailspin for three weeks. As such, it's safe to assume that many traders are holding large short AUD positions. However, on Friday the employment data for Australia is due to be released. It is very likely that with this key piece of economic information soon to be made public, the AUD could experience a short-term rally leading up to the data on Friday as traders pare down their short positions. The point here is that economic indicators can affect prices directly (following their release to the public) or indirectly (as traders massage their positions in anticipation of the data.)

After you follow the data for a while, you'll become very familiar with the nuances of each economic indicator and what part of the economy they are measuring and what importance the market is placing them, eg the likely impact, even if it will have an impact at all.

Besides knowing when all the data will hit the wires, it is vitally important that you know what economists and other market pundits are forecasting for each indicator. For example, knowing the economic consequences of an unexpected monthly rise of 0.3% in the producer price index (PPI) is not nearly as vital to your short-term trading decisions as it is to know that this month the market was looking for PPI to fall by 0.1%.

General information regarding major economic indicators:

When focusing exclusively on the impact that economic indicators have on price action in a particular market, the foreign exchange markets are the most challenging, and therefore, have greatest potential for profits of any market. Obviously, factors other than economic indicators move prices and as such make other markets more or less potentially profitable. But since a currency is a proxy for the country it represents, the economic health of that country is priced into the currency. One very important way to measure the health of an economy is through economic indicators. The challenge comes in diligently keeping track of the nuts and bolts of each country's particular economic information package. Here are a few general comments about economic indicators and some of the more closely watched data.

Most economic indicators can be divided into leading and lagging indicators.

Leading indicators are economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are used to predict changes in the economy.

Lagging Indicators are economic factors that change after the economy has already begun to follow a particular pattern or trend. 


Major Indicators

The Gross Domestic Product (GDP) - The sum of all goods and services produced either by domestic or foreign companies. GDP indicates the pace at which a country's economy is growing (or shrinking) and is considered the broadest indicator of economic output and growth.

Industrial Production - It is a chain-weighted measure of the change in the production of the nation's factories, mines and utilities as well as a measure of their industrial capacity and of how many available resources among factories, utilities and mines are being used (commonly known as capacity utilization). The manufacturing sector accounts for one-quarter of the economy. The capacity utilization rate provides an estimate of how much factory capacity is in use.

Purchasing Managers Index (PMI) - The National Association of Purchasing Managers (NAPM), now called the Institute for Supply Management, releases a monthly composite index of national manufacturing conditions, constructed from data on new orders, production, supplier delivery times, backlogs, inventories, prices, employment, export orders, and import orders. It is divided into manufacturing and non-manufacturing sub-indices.

Producer Price Index (PPI) - The Producer Price Index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices received by domestic producers in the manufacturing, mining, agriculture, and electric utility industries for their output. The PPIs most often used for economic analysis are those for finished goods, intermediate goods, and crude goods.

Consumer Price Index (CPI) - The Consumer Price Index (CPI) is a measure of the average price level paid by urban consumers (80% of population) for a fixed basket of goods and services. It reports price changes in over 200 categories. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.

Durable Goods - Durable Goods Orders measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. A durable good is defined as a good that lasts an extended period of time (over three years) during which its services are extended.

Retail Sales - The retail sales report is a measure of the total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout the nation. It is the timeliest indicator of broad consumer spending patterns and is adjusted for normal seasonal variation, holidays, and trading-day differences. Retail sales include durable and nondurable merchandise sold, and services and excise taxes incidental to the sale of merchandise. Excluded are sales taxes collected directly from the customer.

Housing Starts - The Housing Starts report measures the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Housing is very interest rate sensitive and is one of the first sectors to react to changes in interest rates. Significant reaction of start/permits to changing interest rates signals interest rates are nearing trough or peak. To analyse, focus on the percentage change in levels from the previous month. Report is released around the middle of the following month.


Technical Indicators

Forex EducationHere are a few of the more common types of indicators used in technical analysis:

Trend indicators - Trend is a term used to describe the persistence of price movement in one direction over time. Trends move in three directions: up, down and sideways. Trend indicators smooth variable price data to create a composite of market direction. (Example: Moving Averages, Trend lines)

Strength indicators - Market strength describes the intensity of market opinion with reference to a price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume)

Volatility indicators - Volatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations independent of their direction. Generally, changes in volatility tend to lead changes in prices. (Example: Bollinger Bands)

Cycle indicators - A cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators determine the timing of a particular market patterns. (Example: Elliott Wave).

Support/resistance indicators - Support and resistance describes the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines)

Momentum indicators - Momentum is a general term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)


Forex Order Types

Limit Orders - A limit order is an order placed to buy or sell at a certain price. The order essentially contains two variables, price and duration. The trader specifies the price at which he wishes to buy/sell a certain currency pair and also specifies the duration that the order should remain active.

GTC (Good till cancelled) - A GTC order remains active in the market until the trader decides to cancel it. The dealer will not cancel the order at any time therefore it is the customer's responsibility to remember that he possesses the order.

GFD (Good for the day) - A GFD order remains active in the market until the end of the trading day. Since foreign exchange is an ongoing market the end of day must be a set hour.

Stop Orders - A stop order is also an order placed to buy or sell at a certain price. The order contains the same two variables, price and duration. The main difference between a limit order and a stop order is that stop orders are usually used to limit loss potential on a transaction whilst limit orders are used to enter the market, add to a pre-existing position and profit taking. The same variations are used to specify duration as in limit orders (GTC and GFD).

Let's take the following example:

Example: Trader x Buys EUR/USD 100'000 @ 0.9340, he's expecting a 60 to 70 pip move in the market but he wants to protect himself in case he has overestimated the potential strength of the Euro. He knows that 0.9310 is a b support level so he places a stop loss order to sell at that level. Trader x has limited his risk on this particular trade to 30 pips or USD 300.

Another usage of a stop order is when a trader is expecting a price breakout to occur and wishes to grasp the opportunity to 'ride' the breakout. In this case a trade will place an order to buy or sell 'on stop'. To illustrate the logic behind this let's review the following scenario:

Example: Trader x sees EUR/USD breaking through the 0.9390 resistance level. He believes that if this happens, the price of EUR/USD could be headed to 0.9450 or over. At this point the market is at 0.9350 so trader x places an order to initiate a buying position of 500'000 at 0.9392 'on stop'.

OCO - An OCO (order cancels other) order is a mixture of 2 limit and/or stop orders. 2 orders with price and duration variables are placed above and below the current price. When one of the orders is executed the other order is cancelled. To illustrate how an OCO order works let's take the following example:

Example: The price of EUR/USD is 0.9340. Trader x wants to either buy 500'000 at 0.9395 over the resistance level in anticipation of a breakout or initiate a selling position if the price falls to 0.9300. The understanding is that if 0.9395 is reached, he will buy 500'000 and the 0.9300 order will be automatically cancelled.


FX Trading Strategy

Trading successfully is by no means a simple matter. It requires time, market knowledge, market understanding, trading strategy and a large amount of self-restraint.

Anyone who says you can consistently make money in foreign exchange markets is being untruthful. Foreign exchange by nature, is a volatile market. The practice of online currency trading by way of margin increases that volatility exponentially. We are therefore talking about a very 'fast market' which is naturally inconsistent. Following that precept, it is logical to say that in order to make a successful trade, a trader has to take into account technical and fundamental data and make an informed decision based on his perception of market sentiment and market expectation. Timing a trade correctly is probably the most important variable in trading successfully but invariably there will be times where a traders' timing will be off. Don't expect to generate returns on every trade.

Let's enumerate what a trader needs to do in order to put the best chances for profitable trades on his side:

  1. Trade with money you can afford to lose:
    Trading FX markets is speculative and can result in loss, it is also exciting, exhilarating and can be addictive. The more you are 'involved with your money the harder it is to make a clear-headed decision. Money you have earned is precious, but money you need to survive should never be traded.
  2. Identify the state of the market:
    What is the market doing? Is it trending upwards, downwards, is it in a trading range. Is the trend b or weak, did it begin long ago or does it look like a new trend that's forming. Getting a clear picture of the market situation is laying the groundwork for a successful trade.
  3. Determine what time frame you're trading on:
    Many traders get in the market without thinking when they would like to get out, after all the goal is to make money. This is true but when trading, one must extrapolate in his mind's eye the movement that one expects to happen. Within this extrapolation, resides a price evolution during a certain period of time. Attached to this is the idea of exit price. The importance of this is to mentally put your trade in perspective and although it is clearly impossible to know exactly when you will exit the market, it is important to define from the outset if you'll be 'scalping' (trying to get a few points off the market) trading intra-day, or going longer term. This will also determine what chart period you're looking at. If you trade many times a day, there's no point basing your technical analysis on a daily graph, you'll probably want to analyse 30 minute or hour graphs. Additionally it is important to know the different time periods when various financial centres enter and exit the market as this creates more or less volatility and liquidity and can influence market movements.
  4. Time your trade:
    You can be right about a potential market movement but be too early or too late when you enter the trade. Timing considerations are twofold, an expected market figure like CPI, retail sales or a federal reserve decision can consolidate a movement that's already underway. Timing your move means knowing what's expected and taking into account all considerations before trading. Technical analysis can help you identify when and at what price a move may occur. We will look at technical analysis in more detail later.
  5. If in doubt, stay out:
    If you're unsure about a trade and find you're hesitating, stay on the sidelines.
  6. Trade logical transaction sizes:
    Margin trading allows the FX trader a very large amount of leverage, trading at full margin capacity can make for some very large profits or losses on an account. Scaling your trades so that you may re-enter the market or make transactions on other currencies is generally wiser. In short, don't trade amounts that can potentially wipe you out and don't put all your eggs in one basket.
  7. Gauge market sentiment:
    Market sentiment is what most of the market is perceived to be feeling about the market and therefore what it is doing or will do. This is basically about trend. You may have heard the term 'the trend is your friend', this basically means that if you're in the right direction with a b trend you will make successful trades. This of course is very simplistic, a trend is capable of reversal at any time.
  8. Market expectation:
    Market expectation relates to what most people are expecting as far as upcoming news is concerned. If people are expecting an interest rate to rise and it does, then there usually will not be much of a movement because the information will already have been 'discounted' by the market, alternatively if the adverse happens, markets will usually react violently.
  9. Use what other traders use:
    In a perfect world, every trader would be looking at a 14 day RSI and making trading decisions based on that. If that was the case, when RSI would go under the 30 level, everyone would buy and by consequence the price would rise. Needless to say, the world is not perfect and not all market participants follow the same technical indicators, draw the same trend lines and identify the same support & resistance levels. The great diversity of opinions and techniques used translates directly into price diversity. Traders however have a tendency to use a limited variety of technical tools. The most common are 9 and 14 day RSI, obvious trend lines and support levels, Fibonacci retracement, MACD and 9, 20 & 40 day exponential moving averages. The closer you get to what most traders are looking at, the more precise your estimations will be. The reason for this is simple arithmetic, larger numbers of buyers than sellers at a certain price will move the market up from that price and vice-versa.

FOREX Glossary

Bear - Someone who believes the prices/market will decline.

Bear Market - A market in which prices decline sharply against a background of widespread pessimism (opposite of Bull Market).

Bid - The price that a buyer is prepared to purchase at the price offered for a currency.

Bid/Ask Spread - See spread

Bretton Woods Accord of 1944 - An agreement that established fixed foreign exchange rates for major currencies, provided for central bank intervention in the currency markets, and set the price of gold at US $35 per ounce. The agreement lasted until 1971. See More on Bretton Woods.

Bull - Someone who believes the prices/market will rise.

Bull Market - A market characterised by rising prices.

Broker - An agent who handles investors orders to buy and sell currency. For this service, a commission is charged which, depending upon the broker and the amount of the transaction, may or may not be negotiated.

Call Rate - The overnight interbank interest rate.

Cash Market - The market for the purchase and sale of physical currencies.

Convertible Currency - Currency which can be freely exchanged for other currencies or gold without special authorisation from the appropriate central bank.

Counter party - The customer or bank with whom a foreign deal is made. The term is also used in interest and currency swaps markets to refer to a participant in a swap exchange.

Cross Rate - An exchange rate between two currencies, usually constructed from the individual exchange rates of the two currencies, measured against the United States dollar.

Currency Risk - The risk of incurring losses resulting from an adverse change in exchange rates.

Currency Swap - Contract which commits two counter-parties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.

Currency Option - Option contract which gives the right to buy or sell a currency with another currency at a specified exchange rate during a specified period.

Currency Swap - OTC Option to enter into a currency swap contract.

Currency Warrant - OTC Option; long-dated (more than one year) currency option.

Day Trading - Refers to opening and closing the same position or positions within one day’s trading.

Dollar Rate - When a variable amount of a foreign currency is quoted against one US Dollar, regardless of where the dealer is located or in what currency he is requesting a quote.

EMS - Abbreviation for European Monetary System, an agreement between member nations of the European Union to maintain an alignment between the exchange rates of their respective currencies.

European Monetary Union - The principal goal of the EMU is to establish a single European currency called the Euro, which will officially replace the national currencies of the member EU countries in 2002. Currently, the Euro exists only as a banking currency and for paper financial transactions and foreign exchange. The current members of the EMU are Germany, France, Belgium, Luxembourg, Austria, Finland, Ireland, the Netherlands, Italy, Spain and Portugal.

Exchange Rate Risk - See Currency Risk.

Federal Reserve (Fed) - The Central Bank of the United States.

Fixed Exchange Rate - Official rate set by monetary authorities for one or more currencies. In practice, even fixed exchange rates are allowed to fluctuate between definite upper and lower bands, leading to intervention.

Flat / Square - To be neither long nor short is the same as to be flat or square. One would have a flat book if he has no positions or if all the positions cancel each other out.

Floating Rate Interest - As opposed to a fixed rate, the interest rate on this type of deal will fluctuate with market rates or benchmark rates. One example of a floating rate interest is a standard mortgage.

Foreign Exchange Swap - Transaction which involves the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of the conclusion of the contract (short leg), at a date further in the future at a rate agreed at the time of the contract (the long leg).

Foreign Exchange (or Forex or FX) - The simultaneous buying of one currency and selling of another in an over-the-counter market. Most major FX is quoted against the US Dollar.

Forward - A deal that will commence at an agreed date in the future. Forward trades in FX are usually expressed as a margin above (premium) or below (discount) the spot rate. To obtain the actual forward FX price, one adds the margin to the spot rate. The rate will reflect what the FX rate has to be at the forward date so that if funds were re-exchanged at that rate there would be no profit or loss (i.e. a neutral trade). The rate is calculated from the relevant deposit rates in the 2 underlying currencies and the spot FX rate. Unlike in the futures market, forward trading can be customized according to the needs of the two parties and involves more flexibility. Also, there is no centralized exchange.

Fundamental Analysis - Thorough analysis of economic and political data with the goal of determining future movements in a financial market.

GTC - "Good Till Cancelled". An order left with a Dealer to buy or sell at a fixed price. The order remains in place until it is cancelled by the client.

Hedging - The practice of undertaking one investment activity in order to protect against loss in another, e.g. selling short to nullify a previous purchase, or buying long to offset a previous short sale. While hedges reduce potential losses, they also tend to reduce potential profits.

High/Low - Usually the highest traded price and the lowest traded price for the underlying instrument for the current trading day.

Initial Margin - The required initial deposit of collateral to enter into a position as a guarantee on future performance.

Interbank Rates - The Foreign Exchange rates at which large international banks quote other large international banks.

Limit Order - An order to buy at or below a specified price or to sell at or above a specified price.

Long Position - A market position where the Client has bought a currency he previously did not hold own. Normally expressed in base currency terms, e.g., long Dollars.

Margin - Customers must deposit funds as collateral to cover any potential losses from adverse movements in prices.

Margin Call - A demand for additional funds. A requirement by a clearing house that a clearing member (or by a brokerage firm that a client) brings margin deposits up to a required minimum level to cover an adverse movement in price in the market.

Market Maker - A dealer who supplies prices and is prepared to buy or sell at those stated bid and ask prices. A market maker runs a trading book.

Maturity - Date for settlement.

Offer - The price, or rate, that a willing seller is prepared to sell at.

One Cancels Other Order (O.C.O. Order) - A contingent order where the execution of one part of the order automatically cancels the other part.

Open Position - Any deal which has not been settled by physical payment or reversed by an equal and opposite deal for the same value date.

Over The Counter (OTC) - Used to describe any transaction that is not conducted over an exchange.

Overnight Trading - Refers to a purchase or sale between the hours of 9.00 pm and 8.00 am. On the following day.

Pip (or Points) - The term used in currency market to represent the smallest incremental move an exchange rate can make. Depending on context, normally one basis point (0.0001 in the case of EUR/USD, GBD/USD, USD/CHF and .01 in the case of USD/JPY).

Political Risk - The uncertainty in return on an investment due to the possibility that a government might take actions which are detrimental to the investor’s interests.

Resistance - A price level at which you would expect selling to take place.

Risk Capital - The amount of money that an individual can afford to invest, which, if lost would not affect their lifestyle.

Rollover - Where the settlement of a deal is rolled forward to another value date based on the interest rate differential of the two currencies.

Settlement - Actual physical exchange of one currency for another.

Short - To go `short` is to have sold an instrument without actually owning it, and to hold a short position with expectations that the price will decline so it can be bought back in the future at a profit.

Spot - A transaction that occurs immediately, but the funds will usually change hands within two days after deal is struck.

Spread - The difference between the bid and offer (ask) prices; used to measure market liquidity. Narrower spreads usually signify high liquidity.

Stop Loss Order - An order to buy or sell at the market when a particular price is reached, either above or below the price that prevailed when the order was given.

Support Levels - A price level at which you would expect buying to take place.

Technical Analysis - An effort to forecast future market activity by analysing market data such as charts, price trends, and volume.

Tomorrow to Next - Simultaneous buying and selling of a currency for delivery the following day and selling for the next day or vice versa.

Two-Way Price - Rates for which both a bid and offer are quoted.

US Prime Rate - The rate at which US banks will lend to their prime corporate customers.

Value Date - Settlement date of a spot or forward deal.

Variation Margin - An additional margin requirement that a broker will need from a client due to market fluctuation.

Volatility - A statistical measure of a market or a security’s price movements over time and is calculated by using standard deviation. Associated with high volatility is a high degree of risk.


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