The foreign exchange market is an ecosystem surrounding the buying, selling, and speculation of currencies made up of commercial companies and retail forex brokers, banks and investment management firms, central banks, and hedge funds. There are more than $5 trillion exchanging hands daily; more than equity and futures markets combined.
Forex traders and brokers come together through digital software to exchange currencies, traded in pairs such as EUR/USD meaning EUR vs. USD. The method is OTC (Over-the-Counter) and refers to the direct trade between two parties without the intervention of an intermediary.
THE ADVANTAGES OF OTC – DAY TRADING
Forex traders use OTC through brokers, thereby eliminating the central futures and stock exchange clearing houses. The OTC structure reduces the costs involved due to the automated trading software making it more accessible to millions of day traders who have direct access to the OTC spot forex market, without having to wait for country markets to open.
Furthermore, the internet gives traders advanced trading technology, which speeds up transaction times, enabling faster trading to make profits in short trading sessions according to market volatility.
Another advantage is the high liquidity of the Forex market. Daily forex trading volume is estimated to be over 50 times greater than the NYSE (New York Stock Exchange). The reasons for this is because the forex market is a speculation based trading ecosystem, rather than the physical exchange of currency, and the trades are executed in currency pairs.
WHAT IS A CURRENCY PAIR
Forex trading in pairs is the simultaneous buying of one currency and selling another, which is in effect traded as a single unit.
In the example of the EUR/USD pair, the Base Currency is the Euro. Therefore, you sell USD and buy EUR
Ask and Bid Price.
The Bid Price the price at which a trader is willing to SELL a currency pair. The Ask Price is the price the trader is willing to BUY a currency pair.
Major Currency Pairs
The EUR/USD is the most massively traded and also the most liquid pair traded on world FX exchanges. If you see EUR/USD = 1.2500, it means that one Euro is the base currency and the counter currency or quote currency is the US Dollar.
This means that you pay $125 to buy Euro 100
Currency pairs are categorised according to daily traded volume for a pair and the most widely traded base currency is the US Dollar: EUR/USD, GBP/USD, USD/JPY, AUD/USD, USD/CHF.
Trade Tip: Australia (AUD) and Canada (CAD) and New Zealand (NZD), are countries that have massive commodities. The general rule is for commodities prices to drop when the dollar is stronger than other major currencies, and the reverse happens; commodities prices move higher if the dollar devalues against other major currencies.
Minor Currency Pairs and Exotics
Minor currency pairs are those that are not associated with the US Dollar. These pairs referred to as “crosses” are not as liquid as the major pairs; a cross currency transaction that does not use the US Dollar as a contract settlement currency that includes pairs of fiat such as Euro/GBP or GBP/JPY. The majority of crosses will be in Euros and Japanese Yen and with the Brexit situation, many forex traders have set up separate positions using the Euro as the base currency to trade with the British Pound.
Emerging markets have pairs that may not be as liquid as the majors, but they do provide wider spreads so have become an area where traders can set trades using an exotic currency pairs such as USD/SGD (US Dollar /Singapore Dollar).
DAY TRADING FOREX- HOW IS FOREX TRADED
Forex trading has emerged as a significant trading market through the internet and the development of software, where brokers have set up to trade currencies in a retail ecosystem.
FX TRADING- CONTRACTS
Spot Forex Contracts vs. Future Forex Contracts
- A Currency Future is a legally binding contract, which obligates both parties involved in the trade to exchange the currency pair at a future date and the stated exchange rate.
- Spot FX; two currencies are exchanged at the spot rate (the agreed settlement rate).
According to Nasdaq.com, OTC Forex traders exchange a staggering five trillion dollars a day worldwide.
To summarise, the main determining difference between futures and spot FX is the physical exchange date. With currency futures, the delivery date is distant, and with spot FX the rate is immediate.
Options Forex Contracts
- A currency option contract gives buyers the right without obligation, to buy and sell a currency with a specified rate and within a specific period.
The buyer pays the seller a forward premium, which varies and is dependent on the contractual exchange requirements or the OTC option price. Corporations, financial institutions, and individuals use currency options as a hedging mechanism against unfavourable exchange rate movement.
How Currency Options Work
There are two options for Investors: Calls and Puts.
The holder of a call option has the right without obligation, to buy an underlying asset at the strike price, a quoted price with a time limit. Should the asset fail to reach the strike price during the specified time, the trade expires as worthless.
Investors use the call option to buy when they believe the underlying asset price will rise. Adversely, they sell a call (known as writing an option) if they think the price is going down.
The option holder can sell an underlying asset at the strike price. The seller/writer of the put option is then obliged to buy at the specified strike price. Put options are exercised any time before expiry, which means that an investor can buy puts believing the underlying stock price will go down, or they can sell if they forecast an increase in asset value.
Put Buyers hold “long,” speculating that there will be leverage or that by keeping for a more extended period, they are insuring against short term price fluctuation.
Put Sellers hold “short” because they expect the market to either stay stable or for upward movement. The worst-case scenario for a put seller is a downturn in the market: At expiration, the maximum profit is only achieved if the price is at or above the strike price. The other side of this is that for the uncovered put seller (writer) there is no limit to the maximum loss!
A bullish investor thinks the Euro will go up against the USD, so he purchases a currency call option on the Euro. The strike price is $115 (currency prices are quoted 100 x the exchange rate). The spot purchase rate for the Euro $110 and let us assume that the expiration Euro spot value will be $118.
This means that the currency option expires “in the money,” giving the investor a profit of $300 (the difference between $115 and $118 is $3 x 100), minus the premium the investor paid for the currency call option.
Margin and Settlement of Options
Option sellers are typically required to have a deposit margin due to the mechanics of the trading operation: Limited Profit or Unlimited Losses. On the other hand, option buyers have a different scenario whereby they pay a premium for the limited loss and unlimited profit scenario.
Calculating Required Margin Example:
If you wanted to use US Dollars to buy Euro 1,000, with EUR/USD = 1.25, and your Forex broker asks for a 2% deposit. Therefore, each Euro costs $1.25, so you need to sell$1250 to buy EUR1, 000.
Margin Deposit- 2% margin is the same as a 50:1 leverage the calculation = 1,000 × 1.25 × 0.02 = $25.
If the leverage ratio were 25:1, the calculation would be – 1/25 = 0.04, which is 4%, which would make the required margin on your EUR 1,000 double to $50.
- A currency or cross-currency swap between two parties, as an off the book contract, where they are seeking to reduce the cost of borrowing a foreign currency or are hedging against exposure to an exchange rate.
For Example: In the swap, ‘A’ receives EUR 10 million, and ‘B’ gets $14 million it implies a EUR/USD exchange rate of1.4. When the agreement expires, they will swap back at the same exchange rate to terminate the contract.
FX TRADING – ORDERS
For Forex trading, there are two specific orders – Market and Pending.
- A market order makes a buy or sell at “the price” quoted on the broker platform. The trader clicks either, a buy or sell, at the market price and the trade is executed – meaning there is no turning back.
For example, the bid price for GBP/USD is 1.2140 with the “ask” price at 1.2142, which is the market price that the trader would pay by executing an instant buy order at the “ASK” price.
- A pending order is setting a buy or sell request to trade at a specific future price when the trade automatically executes.
Pending orders give traders more insurance against losses with varying degrees of slippage; the difference between the price set by the trader, and the final execution of trade price. However, it is essential to note that the trader’s price setting for the different loss reducing functions may turn out to be worse than the original price.
The MT4 menu only displays two types of pending order: To place a Buy Limit and Sell Stop order, the trader places the cursor below the current market price. To set a Sell Limit and Buy Stop, the trader places the cursor above the current market price.
However, we have included additional information all the types you may find as a beginner.
UNDERSTANDING FOREX - PENDING ORDERS
Limit Entry Order
- Traders place limit entry orders to buy below or sell above market price.
For Example, GBP/USD is at 1.2030, and the trader wants to go short if the price reaches 1.2050. Rather than wait for the price to reach the 1.2050 and physically press the button to execute the sell market order, the trader sets a sell limit order, that automatically executes the trade when the price reaches 1.2050.
To summarise: A limit order is set to BUY below current market price and will be at a rate equal to or lower than the specified amount. Conversely, a limit order to SELL above current market price executes at a price that is higher or equal to the specific amount.
Stop Entry Order
- A trader will place a stop entry order at a specific price to buy above or sell below the market price.
For Example: if EUR/USD is trading at 1.2030 and the trader believes that the price will continue to go up to reach at least 1.2040, he can place a stop entry order to execute or get out of the trade when the price reaches his trading goal at 1.2040.
Stop Loss Order
- A stop loss order is used by traders to prevent losses if the trade goes against prediction.
How does a Stop Loss Order work?
A trader places a Stop Loss Order to buy or sell once the asset trade reaches a specified price. The trader calculates the limit to set the stop loss at a percentage below the asset purchase price at say 10% or ten pips in forex trading. The stop loss is useful during the trade; only removed on the execution of the deal or the trader cancels the order.
For Example: If you trade a long buy GBP/USD at 1.2210, you will set your maximum loss limit by setting a stop loss order at 1.2200. Assuming your prediction of a price increase and the GBP/USD falls to 1.2200 rather than moving higher, the trading platform automatically executes the SELL order at your stop loss (which is the best available price!) thereby closing your position for a loss of 10-pips.
One Cancels Other
- OCO (one cancels the other) is two orders: one order executes, automatically cancelling the second order.
- OCO = limit order combined with stop order on the automated trading platform
Professional or experienced traders utilise this method to mitigate risk, and it is especially useful when trading “breakouts” or “retracements.” For example, if a trader wanted to trade a break below market support or above market resistance, the trader would enter the market by placing an OCO using a sell stop and a buy stop. MT4 does not have an OCO function, and beginner traders can download an EA (Expert Advisor) to add this functionality.
WHAT IS A FOREX TRADING PLATFORM
A forex Trading Platform is, in essence, a broker platform providing specialised software that maintains a trading account within the Foreign Exchange market and ecosystem.
There are two types of forex trading platforms: Commercial platforms, which target day and retail traders, and they are characterised by their easy to use functions, and Prop platforms more suited to the specific requirements and trading style of large brokerages.
Day traders and investors find the trading platforms with the lowest fees preferable, especially for traders who use scalping as their primary trading strategy.However, lower fees often mean fewer features and trading tools. Another limiting aspect is the equity required and the margins set by the platform broker.
The most popular platform used by the majority of Forex Trading Brokers is MetaTrader (MT4 and MT5 – created by MetaQuotes Software Corporation originating in Russia).
Forex Trading beginners are advised to start on the most widely supported and generic platform where they can learn to use the basic trading strategies before transferring to more sophisticated levels. Every platform will give traders the tools to manage trading accounts with market analysis and real-time signals. Opening a demo account is often the best place for new traders to start, as this enables them to fine-tune their trading temperament and formulate disciplined trading technique using simulated money before spending their own bankroll.