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FX INSIDER

BALBOA PRESS

Contents

About the Author.....................................................ixAcknowledgements.....................................................xiDisclaimer...........................................................xiiiPreface..............................................................xvIntroduction.........................................................xixChapter 1: The World Of Foreign Exchange.............................1Chapter 2: Currencies: The Inside Story..............................14Chapter 3: Know Your Markets.........................................29Chapter 4: Capital: Risk Management..................................35Chapter 5: Technical Analysis........................................41Chapter 6: Fundamental Analysis......................................60Chapter 7: Trading Strategies........................................80Chapter 8: Order Types & Putting Them On.............................98Chapter 9: Developing & Planning Trades..............................110Chapter 10: Managing Positions Once they're Live.....................121Chapter 11: Trading Psychology.......................................125Chapter 12: How to Set Up your Trade Station.........................131Chapter 13: Choosing a Trading Platform..............................137Conclusion...........................................................141Glossary.............................................................143

Chapter One

Forex = Foreign Exchange, FX, Spot FX, Currency Trading Market

People have been borrowing, lending and exchanging money for centuries, and as long as trade and investment continues in a world where sovereign governments control national currencies, they must continue to do so. The foreign exchange market exists to facilitate this conversion of one national currency into another.

I won't bore you to tears with a detailed history of foreign exchange, as this book is purely about trading and the history behind the market isn't relevant, anyway. Put simply, the Forex market began to emerge in 1978 when the worldwide currencies were allowed to `float' according to supply and demand.

Originally it was limited to banks and central banks. This was mainly due to the counterparty and credit risks involved with transacting in the market. Each bank was given a credit rating by an independent ratings agency, and this would be used to set credit lines with other banks in the market. If you had a bad credit rating, you didn't get to trade with many, if any, banks at all. When I first started at Citibank in 1990, we wouldn't trade with any institution that had a credit rating below AAA-minus. We had to check the credit rating of irregular counterparties before every trade to make sure they could settle the transaction when the deal matured. This process was still being carried out into the late nineties.

The central banks at this stage were primarily focused on maintaining economic stability and didn't get involved in the market unless absolutely necessary. They would intervene directly in the market when there was excessive volatility or extreme one-way moves in their currencies.

Then, during the eighties, corporations that were clients of the banks started speculative trading outside their normal foreign exchange operations. The market began to evolve rapidly as the number of players in it grew exponentially. Trading at this stage was conducted through brokers over phones, and the deals were confirmed via telex. Access to the market involved paying exorbitant brokerage fees and large spreads, making it largely inaccessible to the man on the street.

Then, around 1995, there was progressive development and reform of the financial sectors. These factors, combined with the development of information and communication technologies and the establishment of an international banking and settlements system, led to massive and rapid expansion of the foreign exchange market.

It was at this time the Bank of International Settlements (BIS) centralised all clearing operations in the market. If you dealt with a bank you didn't have credit with, the counterparty name would be automatically switched to a bank you did have credit with. This removed a lot of the counterparty and credit risks that were previously hindering the growth of the market. Trading was now being conducted over electronic broking networks and this had a huge impact on the volume and speed of trading. Trade processing was faster, more efficient and a lot more accurate, and it enabled all financial institutions to trade in the market, regardless of their credit rating.

Then, during the late nineties, a number of the larger banks developed trading platforms targeting smaller banks who wanted to reduce their costs. By transacting directly with the bigger banks, the smaller banks could eliminate all brokerage costs. It turned out to be a booming business and led to rapid development of trading (broking) platforms.

Through the success of these trading platforms, the larger banks expanded their market to include the retail sector. By 2005 the new trading platforms gave the retail trader access to the market with the same speed, pricing and execution that commercial traders have, without any of the costs.

On top of this margin, lending facilities enabled investors with very little capital to trade vast sums of money. You could leverage your capital up to 500:1, making it possible to make large amounts of money in a very short period of time. It was the perfect market, and it was now officially open to the retail market.

Foreign Exchange Today

The Forex market today is the largest global financial market in the world. Its growth has been unprecedented and continues to be unequalled by any other trading market. This can be credited to the ease of access to the market and the fact that the principles and conventions applied in the Forex market are universal.

Participants now include banks, central banks, currency speculators, corporations, hedge funds and many other financial institutions. They are connected over an electronic network, which allows them to trade the currencies of most countries of the world. Foreign currencies are simultaneously bought and sold across global markets and traders' investments increase or decrease in value based upon currency movements.

One of the big appeals of the Forex market today is that it is open for investors of all levels, and you can work from anywhere at any time as long as you have access to the Internet. The Forex market also responds to real time events and news, creating ongoing volatility and trading opportunities. You can profit in both rising and falling markets. Also, unlike the stock markets, you don't have to wait for a bell to ring to start and finish trading. The markets open 5am Monday morning in Sydney and close at 5pm Friday night in New York. You can basically trade around the clock.

The wholesale market itself has not changed much in the past ten years; it's just become a whole lot more efficient. Technology advances have reduced the head count of many of the larger trading teams, and since the global financial crisis, the risk appetites of many of the banks have been curtailed somewhat.

They have channelled a lot of their resources into expanding and developing more efficient trading platforms for the retail market. The competition in the market place nowadays is such that the retail trader can now get better pricing than a lot of the bank traders.

Where Does Retail Forex Fit In?

Being part of the market is one thing, but understanding where you fit in the food chain is also very important. Understanding the market and where your prices come from will help explain what's happening with the execution of your trades and give you confidence that your trades will be executed efficiently and your consequent risk managed adequately.

It's a common misconception that brokers skew their prices to stop you out, or change their rates to make more money off you when you try to hit the market live. This couldn't be further from the truth.

The retail traders rely on the retail broker for all their trading needs. The retail brokers get all their pricing and execution from the commercial banks, which in turn access the Forex market to cover their risk.

Now if there are any hiccups or volatility in the main market, this will be replicated down the trade chain. The rates the retail brokers get from commercial banks are directly passed on to you. It's the commercial banks reacting to market fluctuations that are causing all the price changes and ensuing havoc. They send down the rates and you either trade or not. Sometimes the price changes will work in your favour and sometimes they will be against you. Most traders don't dwell on this and expect it to work itself out over the long haul. So next time you see the rates jump around and you think it's the broker messing with the rates, think again.

Why Do The Currencies Fluctuate?

It all comes back to simple economics and the theory of supply and demand. If there is too much supply (more sellers than buyers), the currencies go down and if there is too much demand (more buyers than sellers), the currencies go up. Simple as that!

But there are three main reasons this imbalance occurs: commercial transactions, economic data releases and political/ central bank intervention.

Commercial transactions include the business of importing and exporting, as well as mergers and acquisitions. Since the beginning of time, the business of importing and exporting has created huge flows of foreign exchange. It was in fact one of the main reasons foreign exchange markets began.

Large shipments of goods from one country to another require transfers of large sums of money as payments are made. This sends shock waves through the market as the banks cover these customer flows. For example, we had to cover a transaction where Qantas (Australian company) had to pay for ten new planes from Boeing (American company). The deal was worth close to $800 million, and they were required to make payment in USD. We had to buy 800 million USD and sell the Australian dollar equivalent. This transaction alone sent the AUD/USD down 200 points, as supply far outweighed demand.

In this modern age of globalisation, it is not uncommon for multinational companies to expand offshore and buy/sell businesses abroad, commonly referred to as mergers and acquisitions. These transactions have the same impact as the importer/exporter flows but are more often much larger amounts, invariably in the billions. These transactions will not only change the value of the currency dramatically but can often alter the trend of the currency.

These days, economic data releases are the major reason currencies fluctuate. These economic data releases give an overall view of the state of the economy and, more importantly, the direction of interest rates. The overall health of the economy is assessed through these key releases, and they create instant trading opportunities. They are scheduled a year in advance in all developed countries so you can easily plan your trading around these key market movers. We will be going into a lot more detail when we look at fundamental analysis in chapter 6.

Last but not least is political and central bank intervention. The currencies are continually monitored by each country's central bank. If there is any irregular activity or the markets become unstable and liquidity dries up, the central banks will intervene to stabilise the markets. This is usually a very dramatic event and once the central bank is seen in the market, it is a signal that the move is over or will reverse quickly.

The politicians, on the other hand, do not have access to intervene directly in the market. Instead, they hold press conferences and make sweeping statements about their displeasure at current moves or levels of the currency. This is commonly referred to as `jawboning'. The more important the politician, the more the market listens. Because there is no direct intervention in the market, this type of intervention is not as potent or long-lasting.

What is a Forex Deal and What Does it Involve?

Forex trades are non-deliverable trades: Currencies are not physically traded, but rather, as soon as a trade is executed a contract for difference (CFD) is agreed upon and performed between two parties-trader and broker.

A contract for difference is a legally binding agreement between the client and the CFD provider to exchange at the close of a contract the difference between the price of the underlying financial instrument at the opening and the price at closing. CFDs simply mirror the underlying market and allow investors to gain exposure to these markets without the obligations and costs of ownership.

The contract is comprised of three components:

1. The currency pair

2. The principal amount

3. The exchange rate

Example: An order to buy Aussie dollars

The Currency Pair

Every time you enter into a trade, one currency is bought and another sold simultaneously. The first currency in the exchange rate is the base currency and the second currency is the terms currency. In the above example, the Australian dollar is the base currency and the USD is the terms currency.

Note: A cross rate refers to any quote that does not include the USD. They are generated by crossing the major currencies together.

When trading, you refer to the currency pair you are trading by the base currency only. When doing so, it is taken for granted that it is against the USD.

Example:

If you bought EUR/USD, you would say your bought EUR.

If you sold GBP/USD, you would say you sold GBP.

If you traded a currency pair where the USD is the base currency, then you would have to quantify which currency that was so you would have to say the whole pair.

Example:

If you bought USD/YEN, you would say you bought USD/YEN.

If you sold USD/CAD, you would say you sold USD/ CAD.

If you are trading a cross rate, then you would say the whole cross rate in the same way you would if the USD was the base currency.

Example:

If you bought EUR/GBP, you would say you bought EUR/GBP.

If you sold EUR/CHF, you would say you sold EUR/ CHF.

FX Insider

The Principal Amount

This is the amount of base currency involved in the trade, commonly referred to as the traded amount.

The Exchange Rate

Is the defined rate at which the deal is transacted or exchanged. This will be the point from where your profits and losses are calculated. It also tells a buyer how much of the terms currency must be paid to obtain one unit of the base currency. Likewise, it tells a seller how much is received in the terms currency when selling one unit of the base currency.

Example:

An exchange rate for AUD/USD of 1.0620 specifies to the buyer of AUD that 1.0620 USD must be paid to obtain one AUD.

Additional Trading Terminology

Bid Rate = Sell Rate (left hand side)

If you are hitting the market live, this is the rate at which you can sell the base currency. Alternatively, if you have placed a pending limit order to buy (below the market), then this is the level the market needs to go below to set your order.

Offer Rate = Buy Rate (right hand side)

If you are hitting the market live, this is the rate at which you can buy the base currency. Alternatively, if you have placed a pending limit order to sell (above the market), then this is the level the market needs to go above to set your order.

Example: The EUR/USD is quoted

1.2594(8)-1.2596(8)

Hitting the market live you can:

Sell at 1.2594(8)-Bid

OR

Buy at 1.2596(8)-Offer

Spread

This is the difference between the bid (buy) and the offer (sell) rate. In the example above, the spread is 1.5 points.

A Point or a Pip

They mean the same thing. When we refer to trades, we often refer to how many points we have made or lost. Each cent in every currency is made up of 100 points.

When you are trading Forex you are basically trading the third and fourth decimals. For example (EUR/USD) from 1.4200 to 1.4300 cents, there is 100 points. Traders refer to all moves in points or pips.

The broker market has become so competitive that many have now introduced a fifth decimal to try and tighten the spread even more. In the example above, this is why the price is quoted:

1.25948-1.25968

Long

When you buy the base currency, you would say you are long.

Example:

If you bought EUR/USD at 1.2575, you would say you are long Euro at 1.2575.

Short

When you sell the base currency, you would say you are short.

Example:

If you sold GBP/USD at 1.6348, you would say you are short GBP at 1.6348.

Square

Means you have no open positions. You are neither long nor short.

Stop Loss (S/L Order)

This is an order or transaction where your position is squared to prevent further losses, or to stop your losses.

Example:

You are long GBP at 1.6348. You set a stop loss order in place at 1.6330. If GBP moves below 1.6330, your position will be squared automatically to prevent you from incurring further losses.

Take Profit (T/P Order)

This is an order or transaction where your position is squared to lock in your profits, or to take profit.

Example:

You are long NZD at 0.7875. You set a take profit order in place at 0.7900. So if the NZD rallies to 0.7900, your position is squared up automatically to lock in your profits.

Margin Trading

Margin trading allows investors to buy and sell assets that have a greater value than the capital in their account.

Forex trading is typically executed on margin accounts, and the industry practice is to trade on relatively small margin amounts since currency exchange rate fluctuations tend to be less than one or two per cent on any given day.

Leverage

This is the ratio of investment to actual value. So a ratio of 1:100 would allow you to trade $100,000 (principal amount) with just $1,000 invested in your trading account.

Exposure

This is the potential amount of loss you may incur from fluctuations in the market price.

Example:

If you were long 1 million AUD/USD at 1.0520 and you have a stop loss in place at 1.0510, your exposure is 10 points, or $1000 USD.

Risk

Every foreign exchange trade involves the risk of an adverse change in price of the currency you purchased against the currency you sold.

(Continues...)

Excerpted from FX INSIDERby Bradley Gilbert Copyright © 2012 by Bradley Gilbert. Excerpted by permission of BALBOA PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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