Beginners Guide to Forex - Module 2
Module 2: Fundamental concepts relating to the forex market
As your journey continues, it’s extremely important that you understand the fundamental concepts relating to the forex market. You may already be familiar with some of these concepts from other markets; however there are some key differences.
Let’s start with understanding currency pairs. Currencies in the retail forex market are traded in pairs. You will buy one currency and simultaneously sell another, so when you “buy the EUR/USD” you are essentially buying Euros and selling US Dollars. If you “sell the EUR/USD” you are selling Euros and buying an equivalent amount of US Dollars.
The US Dollar
The US dollar features in all of the top-6 most traded currency pairs. Not surprisingly, these are the ‘Majors’ – EUR/USD (28% of daily turnover), USD/JPY (14%), GBP/USD (9%), AUD/USD (6%), USD/CAD (5%) and USD/CHF (4%). For many years, the USD has been regarded as the world’s “reserve currency” and many governments around the world hold substantial investments denominated in USD. In addition, many products globally are priced in USD, especially in the commodities markets. The majority of international trade is either executed in, or with reference to, the USD.
The Euro came into existence on 1st January 1999, signalling the end of currencies such as the Deutsche mark, the French franc, and the Italian lira. Some 23 countries currently use the euro as their currency, representing a population in excess of 328 million people. A further 175 million people use a currency that is pegged to the Euro. After the USD, the Euro is the second most traded currency in the world. As a pair, the EUR/USD represents 28% of average daily turnover in the FX market. This is double that of the nearest rival, the USD/JPY at 14%.
The Japanese Yen
The yen is the official Japanese currency and it is denoted by JPY. The yen was established as the official unit of currency by the New Currency Act of 1871. Rising crude oil prices influence the Yen. Because it imports all of its oil as an export-dependent nation, Japan is highly sensitive to rising energy costs. One thing to notice is that when the strength of the yen rises, it tends to hurt the manufacturing industry of Japan, which is a large component of the Japanese economy. At times of a rapidly strengthening JPY (represented by falling USD/JPY and EUR/JPY), it is not uncommon for traders to become wary of the risk of intervention by the central bank, the Bank of Japan, aiming to dampen the strength of the JPY and ease the pressure this places on the export driven economy.
The Swiss Franc
The Swiss franc, or Swissy and CHF, is the legal tender of Switzerland and Liechtenstein. The franc banknotes are issued by the Swiss National bank, also known as the central bank of Switzerland; the coins are issued by the Swiss Federal Mint, Swissmint. The Swissy is the only version of the franc still issued in Europe. The Swiss franc is hailed as a safe haven currency due to the history of political neutrality, low inflation, and the legal requirement that at least 40% of the currency be backed by gold reserves.
The Australian Dollar
The Australian dollar, or Aussie, is denoted by the symbol AUD. Surprisingly, for a country of relatively few people, the AUD plays a key role in the global FX market. According to the 2010 Triennial Central Bank Survey conducted by the Bank for International Settlements, the AUD is the fifth most traded currency in the world, ahead of the Swiss franc and the Canadian dollar. This is largely due to the fact that the country has relatively stable government, the currency is allowed to float freely and perhaps most importantly, it is regarded as a reflection of the health of the global commodities market. Along with a handful of other currencies including the New Zealand dollar and the Canadian dollar, the AUD is often referred to as a “commodity currency”, due to the substantial influence of commodities on the local economy. In recent years, many traders have traded AUD as a proxy for Asia and China in particular.
What Are The Most Active Times To Trade?
The best times to trade in the Forex market are when there is more than one market open, hence higher volume and higher liquidity.
The market begins each week in New Zealand, followed by Australia, Asia, The Middle East, Europe and then Americas. The U.S. and U.K markets account for about half of all market transactions, and nearly two-thirds of the New York trading activity occurs in the morning hours while the European markets are trading their afternoon session.
Roll-over or Swap – what is it and why does it matter?
Forex positions that are open at the end of the business day are rolled over to the following day. As part of the rollover, positions are subject to a charge or credit based on interest rates of the two traded currencies. This is referred to as swap.
From a conceptual point of view, it is as though you earn interest on the currency you have bought and pay out interest on the currency you have sold. The end result is that you either earn or pay the interest rate differential between the two currencies.
In reality, most brokers apply a swap rate to the transaction to determine how much interest to either pay you or charge you. Most brokers publish their swap rates on their websites or in their platforms. However, if you want to calculate the swap yourself the formula is:
swap rate (short % or long %) x pip value x number of lots x number of days
When working out the swap rate, it is important to consider the settlement date of the transaction. In the spot market (which is what you are trading as a retail trader) the settlement date is two bank days after the execution date. It works like this, if you open your trade on Monday and keep it until Tuesday it counts as if you opened it on Wednesday and kept it until Thursday. However, if you open the position on Wednesday and keep it until Thursday it counts as if you opened it on Friday and kept it until Monday. As a result, trades that remain open at the end of the FX day (5pm New York) on Wednesday will involve three times the amount of swap (paid or earned) than on other days. (NOTE: If your broker is based in the US, this will usually be Wednesday US time – Check with your broker). Swap is usually converted to your base currency at the time of calculation.
A significant benefit of trading Forex is that many brokers offer a platform that will allow you to automate your trading strategy. You can set up your trading system so that it will trade 24 hours a day while the market is open, regardless of whether you are able to sit in front of your computer or not. You can even use the services of a Virtual Private Server (VPS) in a dedicated data centre to increase your execution speed and ensure minimal interruption due to issues you might have with your own pc (such as turning it off by mistake).
Another key benefit of trading Forex is that you can open a mini account and even trade fractional lots. This essentially means you can open an account with an FX broker for as little as $250 and trade micro lots, which reduces risk to as little as one cent per pip. This makes testing trading strategies far less expensive that it it is with a full-sized lot in a standard account where a move of one pip results in a gain or loss of $10 (depending on the pair being traded). The small position size also allows you to fine tune your trades. It is a lot easier to make rational decisions when you are down 50 cents rather than 50 dollars.
Forex trading is one of the riskiest forms of investment available in the financial markets and suitable for sophisticated individuals and institutions. The possibility exists that you could sustain a substantial loss of funds and therefore you should not invest money that you cannot afford to lose.
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