TradeFreedom | Canadian Online Discount Broker Direct Access Trading Canada

Foreign Exchange

This short introduction explains the basics of trading Forex online, a brief explanation of the markets and the major benefits of trading Forex online. There are also two scenarios describing the implications of trading in a bear as well as bull market to better acquaint you with some of the risks and opportunities in the largest and most liquid market in the world. As an additional aid for those who are new to Forex, there is also a glossary at the bottom of this text which explains some of the terms used in connection with currency trading.

Overview

Foreign exchange, forex or just Forex are all terms used to describe the trading of the world’s many currencies. The forex market is the largest market in the world, with trades amounting to more than $1.5 trillion every day. This is more than one hundred times the daily trading on the NYSE (New York Stock Exchange). Most forex trading is speculative, with only a few percent of market activity representing governments’ and companies’ fundamental currency conversion needs.

Unlike trading on the stock market, the forex market is not carried out by a central exchange, but on the “interbank” market, which is thought of as an OTC (over the counter) market. Trading takes place directly between the two counterparts necessary to make a trade, whether over the telephone or on electronic networks all over the world. The main centres for trading are Sydney, Tokyo, London, Frankfurt and New York. This worldwide distribution of trading centres means that the forex market is a 24-hour market.

A currency trade is the simultaneous buying of one currency and selling of another one. The currency combination used in the trade is called a cross (for example, the Euro/US Dollar, or the GB Pound/Japanese Yen.). The most commonly traded currencies are the so-called “majors” – EURUSD, USDJPY, USDCHF and GBPUSD.

The most important forex market is the spot market as it has the largest volume. The market is called the spot market because trades are settled “immediately” or on the spot. In practice this means within two banking days.

Forward Outrights

For forward outrights, settlement on the value date selected in the trade means that even though the trade itself is carried out immediately, there is a small interest rate calculation left. This is because if you trade e.g. NOKJPY, you get almost 7% (annual) interest in Norway and close to 0% in Japan. So, if you borrow money in Japan, to finance the trade as you must have one currency with which to buy or another, and place it in Norway you have a positive interest rate differential. This differential has to be calculated and added to your account. You can have both a positive and a negative interest rate differential, so it may work for or against you when you make a trade. The interest rate differential doesn’t usually affect trade considerations unless you plan on holding a position with a large differential for a long period of time. The interest rate differential varies according to the cross you are trading. On the USDCHF, for example, the interest rate differential is quite small, whereas the differential on NOKJPY is large.

Trading on Margin

Trading on margin means that you can buy and sell assets that represent more value than the capital in your account. Forex trading is usually done with relatively little margin since currency exchange rate fluctuations tend to be less than one or two percent on any given day. To take an example, a margin of 2.0% means you can trade up to $500,000 even though you only have $10,000 in your account. In terms of leverage this corresponds to 50:1, because 50 times $10,000 is $500,000, or put another way, $10,000 is 2.0% of $500.000. Using this much leverage gives you the possibility to make profits very quickly, but there is also a greater risk of incurring large losses and even being completely wiped out. Therefore, it is inadvisable to maximise your leveraging as the risks can be very high. For more information on the trading conditions at TradeFreedom, go to the Account Summary on your Client Station and open the section entitled "Trading Conditions" found in the top right-hand corner of the Account Summary.

Why trade Forex?

24 hour trading

One of the major advantages of trading forex is the opportunity to trade 24 hours a day from Sunday evening (20:00 GMT) to Friday evening (22:00 GMT). This gives you a unique opportunity to react instantly to breaking news that is affecting the markets.

Superior liquidity

The forex market is so liquid that there are always buyers and sellers to trade with. The liquidity of this market, especially that of the major currencies, helps ensure price stability and low spreads. The liquidity comes mainly from large and smaller banks that provide liquidity to investors, companies, institutions and other currency market players.

No commissions

The fact that forex is often traded without commissions makes it very attractive as an investment opportunity for investors who want to deal on a frequent basis.

Trading the “majors” is also cheaper than trading other crosss because of the high level of liquidity. For more information on the trading conditions at TradeFreedom, go to the Account Summary on your Client Station and open the section entitled "Trading Conditions" found in the top right-hand corner of the Account Summary.

50:1 Leverage

With a minimum account of USD 10,000, for example, you can trade up to USD 500,000. The USD 10,000 is posted on margin as a guarantee for the future performance of your position.

Profit potential in falling markets

Since the market is constantly moving, there are always trading opportunities, whether a currency is strengthening or weakening in relation to another currency. When you trade currencies, they literally work against each other. If the EURUSD declines, for example, it is because the U.S. dollar gets stronger against the Euro and vice versa. So, if you think the EURUSD will decline (that is, that the Euro will weaken versus the dollar), you would sell EUR now and then later you buy Euro back at a lower price and take your profits. The opposite trading scenario would occur if the EURUSD appreciates.

Important Forex Trading Terms

Spread

The spread is the difference between the price that you can sell currency at (Bid) and the price you can buy currency at (Ask). The spread on majors is usually 5 pips under normal market conditions. For more information on the trading conditions at TradeFreedom, go to the Account Summary on your Client Station and open the section entitled "Trading Conditions" found in the top right-hand corner of the Account Summary.

Pips

A pip is the smallest unit by which a cross price quote changes. When trading forex you will often hear that there is a 5-pip spread when you trade the majors. This spread is revealed when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of 0.9880. The difference is USD 0.0005, which is equal to 5 “pips”. On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with four decimals, so all you have to do is the cancel-out the four zeros on the amount you trade and you will have one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is quoted with only two decimals.

Trading Scenario – Trading Rising Prices

If you believe that the Euro will strengthen against the dollar you’ll want to buy Euro now and sell it back later at a higher price.
You buy Euro	We quote EURUSD at Bid 0.9875 and Ask 0.9880, which means that you can sell 1 Euro for 0.9875 USD or buy 1 Euro for 0.9880 USD. In this example you buy Euro 100,000, at the quote price of 0.9880 (ask price) per Euro.
The market turns	Later the market turns in favour of the Euro and the EURUSD is now quoted at Bid 0.9894 and Ask 0.9899.
Now you want to sell your Euro and get the profit	You sell Euro at a Bid price of 0.9894.
The profit is calculated as follows:	Sell price-buy price x size of trade (0.9894 minus 0.9880) multiplied by 100.000 = $140 Profit (Note that the profit or loss is always expressed in the secondary currency)

Trading Scenario – Trading Falling Prices

If, on the other hand, you believe that the Euro will weaken against the dollar, you’ll want to sell EURUSD.
You sell Euro	We quote EURUSD at a Bid price of 0.9875 and Ask price of 0.9880 and you decide to sell Euro 100,000 at a Bid price of 0.9875.
The market moves in your favour	The Euro weakens against the dollar and the EURUSD is now quoted at bid 0.9744 and ask 0.9749.
Now you buy back your Euro	You buy EUR at an ask price of 0.9749.
Your Profit/loss is then	Sell price-buy price x size of trade (0.9875 minus 0.9749) multiplied by 100.000 = $ 1260 Profit

Remember that trading EUR 100,000 as we have done in our examples, does not mean that you have to put up Euro 100,000 yourself. It means that you have to deposit 2.0% of Euro 100,000, which is Euro 2,000 on margin as a guarantee for the future performance of your position.

Further Reading

To see how you can trade the forex market and benefit from our toolbox of information and live quotes, please proceed to our Forex Quick Start found under the Trading menu on the toolbar, under Forex.

Glossary

Appreciation	An increase in the value of a currency.
Ask	The price at which you can buy. Traders also speak of an ask price, the price requested. This usually indicates the lowest price a seller will accept.
Base currency	The currency that the investor buys or sells (i.e. EUR in EURUSD).
Bear	Someone who believes prices are heading down. A bear market is one in which there is a sustained fall in prices and which does not look like it will recover quickly.
Bid	The price at which you can sell. Traders also speak of a bid price, the price offered. This usually indicates the top price a purchaser will pay.
Bid/Ask	The Bid rate is the rate at which you sell. The Ask (or offer) rate is the rate at which you can buy.
Bull	Someone who is optimistic about the market. A bull market is characterised by enthusiastic and sustained buying.
cross	When trading currencies, the investor buys one currency against another. These two currencies form the cross: for example, EURUSD.
Cross rate	An exchange rate that is calculated from two other exchange rates.
Depreciation/decline	A fall in the value of a currency.
Exchange rate	What one currency is worth in terms of another, for example the $A might be worth 58 US cents or 70 yen. Currencies traded freely on foreign-exchange markets have a spot rate (applying to trades settled 'spot', ie, two working days hence) and a forward rate. Countries can determine their exchange rates in a variety of ways: a floating exchange rate system where the currency finds its own level in the market; a crawling or flexible peg system which is a combination of an officially fixed rate and frequent small adjustments which in theory work against a build-up of speculation about a revaluation or devaluation; a fixed exchange-rate system where the value of the currency is set by the government and/or the central bank.
EURUSD	Means that you trade EUR against dollars. If you buy Euro you pay in dollars and if you sell Euro you receive dollars.
FX, Forex, Foreign Exchange	All names for the transaction of one currency for another, e.g. you buy £100.00 with $150.25 or sell $150.25 for £100.00.
Interbank	Short-term (often overnight) borrowing and lending between banks, as distinct from banks' business with their corporate clients or other financial institutions.
Interest rate differential	The yield spread between two otherwise comparable debt instruments denominated in different currencies.
Leverage (gearing)	In this case leverage means that the investor only funds part of the amount traded.
Long	To buy.
Long position	A position that increases its value if market prices increase.
Liquid (-ity)	The capacity to be converted easily and with minimum loss into cash. Ultra-short-dated treasury notes are an example of a liquid investment. A liquid market is one in which there is enough activity to satisfy both buyers and sellers.
Margin	The initial amount or deposit required when entering into a position. Margin is a guarantee for future performance.
NYSE	A computerised system providing brokers with the prices of shares and securities traded on the New York stock exchange and over the counter. The quotes are published in real-time.
Open position	A position in a currency that has not yet been offset. For example, if you have bought 100,000 USDJPY, you have an open position in USDJPY until you offset it by selling 100,000 USDJPY.
“Over the counter”	When trading takes place directly between two parties, rather than on an exchange.
Pips	A pip is the smallest unit by which a cross price quote changes. So if EURUSD bid is now quoted at 0.9767 and it moves up 2 pips, it will now be quoted at 0.9769.
Position	Money-market, futures, foreign-exchange and sharemarket traders talk of 'taking a position' which simply means buying or selling one currency cross. 'Position' can also refer to a trader's cash/securities/currencies balance, whether he or she is short of cash, has money to lend, is overbought or oversold in a currency, etc.
Risk	Trying to control outcomes to a known or predictable range of gains or losses. Risk management involves a set of steps which begin with a sound understanding of one's business and the exposures or risks that have to be covered to protect the value of that business. Then an assessment should be made of the types of variables that can affect the business and how best to protect against unwelcome outcomes. Consideration must also be given to the preferred risk profile - whether one is risk- averse or fairly aggressive in approach. This also involves deciding which instruments to use to manage risk, and whether a natural hedge exists that can be used. Once undertaken, a risk-management strategy should be continually assessed for effectiveness and cost.
Secondary currency (variable currency or counter currency)	The currency that the investor trades the base currency against (i.e. USD in EURUSD).
Short position	A position that benefits from a decline in market prices.
Short	To sell.
Speculative	Buying and selling in the hope of making a profit, rather than doing so for some fundamental business-related need.
Spot	A Spot rate is the current market price of an asset.
Spot market	The part of the market calling for spot settlement of transactions. The precise meaning of 'spot' will depend on local custom for a commodity, security or currency. In the UK, US and Australian foreign-exchange markets, 'spot' means delivery two working days hence.
Spread	The difference between the bid and the ask rate.

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