Foreign Exchange Trading

A detailed history of the foreign exchange market exceeds both the scope and purpose of this brief overview. It is important to note that over the last 30 years the Forex market has evolved into its current state as a result of free market exchange rate volatility, technological advances in dealing platforms, regulatory reform, globalization, the democratization of money and the recognition of the Forex markets as an asset class. The constantly changing relative value of one currency against another currency continually creates trading opportunities that are now accessible to virtually anyone, anywhere, anytime of the day or night. The constantly changing exchange rate between currencies and its deep liquidity (approaching 2 trillion dollars a day) attract speculators to the Forex market.

The Forex market is open 24 hours a day for 5.5 days per week. Trading opens on Sunday evening at 5 p.m. New York time (i.e., with the New Zealand open) and closes at 4 p.m. New York time on Friday afternoon.

The Spot Forex Market

The cash foreign exchange market trades on either the "spot" price or the "forward" price. The spot price at which a currency pair is currently trading is determined by the market participants trading the spot market. The "value date" refers to the date on which the trade would settle for delivery if it is not "rolled forward" (see below). The globally accepted settlement convention for spot forex transactions is two (2) business days from the "trade date." In instances where there is a bank holiday, weekend or other day when the banks in the countries represented by the currencies in the currency pair are closed, the value date is adjusted forward to the next date on which the banks are open.

Although the standardized settlement procedure for foreign exchange transactions sets the value date two (2) business days forward from the trade date, in the case of US Dollar versus the Canadian dollar, the value date is one (1) business day forward from the trade date. The procedure for "rolling" a position forward includes an interest rate calculation (see below).

Rollover Procedure for Spot Forex

At the end of each business day, the dealing desk will automatically "roll" all existing open positions to the next value date. The mechanics of a roll involve the simultaneous close of an existing position and the opening of a new spot position. This procedure will create a debit or credit to your account depending on the interest rate differential between the base currency and the counter currency and the direction of your position.

For example, if you are long a currency pair where the overnight rate for the base currency is higher than the overnight rate for the counter currency, you will earn a small credit for positions held overnight and your account statement will reflect the increase. If the opposite is true, your account will be debited for the difference in the interest rate differential.

If you are long the higher yielding currency you should benefit from being able to invest and earn a higher return overnight than what you have to pay for being short the lower yielding currency. So, the credit (in base currency terms) is added to your account when you are long a higher yielding currency overnight. The debit is subtracted from your account when you are long a lower yielding currency overnight.

For example, if you are long the EUR/USD currency pair, it implies owning EUR and being short USD. If short-term interest rates are higher for the EUR versus comparable US interest rates, you would earn that higher rate and pay the lower USD rate when rolling over a spot position. As a result, being long on a currency that has higher interest rates will result in a credit adjustment to your account. Conversely, being long a currency with a lower interest rate will result in a debit adjustment to your account.

The dealing desk will make a debit or credit adjustment for each open currency pair at the end of each business day. Positions that are open past 5:00 p.m. EST are typically automatically rolled forward and will result in an automatic adjustment to your account and will appear in your client reports.

NOTE: Since open positions over a weekend need to be rolled from Friday to Monday (or 3 days), the debit or credit will be three times the normal amount. Also, if there is a holiday, the rollover amounts will also be affected. Finally, end of year or end of quarter periods can result in rollover debits or credits that can be higher or lower than normal -- spot interest rates can be particularly volatile during this period resulting in a wider or narrower interest rate differential for the currency pair.

Bid/Ask and the Spread

Currencies trade in "Pairs." When you trade the Forex market, you are buying one currency in the pair and simultaneously selling the opposing currency in the pair. The first currency in the pair is called the "base currency." The second currency in the pair is called the "counter currency." The Bid is the price at which you may sell a currency. The Ask (or offer) is the price at which you may buy a currency. The difference between the Bid and Ask is defined as the "Spread" and is expressed in "Pips."

For example, if the EUR/USD pair is trading at 1.2800/1.2802, then you may sell EUR/USD at 1.2800 or buy at 1.2802. If you sell the pair you are selling the Euro and buying the US dollar. The difference between the bid and the ask is 2 pips, "the Spread," and the market is said to be "two wide." The spread between the bid and the ask will narrow or widen throughout the trading day depending on the liquidity in the market. For instance, when the New York market closes you may see the spread widen in some pairs because fewer traders are in the market. The spread may change depending upon other market conditions as well.

Although many retail firms have a fixed spread and market the fixed spread as an advantage, fixed spreads are rarely advantageous since they are typically fixed at an artificially wider spread than the spread reflecting true market conditions. The spread in the true market may widen temporarily, but it is almost always brought back into line very quickly during normal market conditions.

The spread of some pairs may widen appreciably, however, as liquidity drops. The USD/MXN (Mexican Peso) may have a 40 pip spread during the US trading session (0800 - 1400 New York time) and may widen to 80 pips or more after the US market closes. Low volume = less liquidity = wider spread.

Major Pairs

Because of the relatively high daily trading volume (depth) and volatility most traders focus their attention on the six major pairs (referred to as "The Majors"): EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, and the AUD/USD. Since the daily volume of these pairs make up a large percentage of the total daily volume of the forex market, no one trader or trade can significantly influence the market prices of the majors.

Non-Major Crosses & Exotics

Other currency pairs have become increasing popular. The EUR/JPY and NZD/USD have proven to have comparable trading opportunities and have tended to be more trend-friendly at particular times then the Majors. In some cases, savvy speculative traders have studied a particular minor pair such as the USD/PLN (Polish Zloty) and profited from their analyses.

Margin, PIP & Profit

The first currency (base currency) listed in a pair determines the MARGIN requirement and the second currency (counter currency) determines the PIP value. What you do (i.e., buy or sell) to the base currency will be the reverse on the counter currency. If you buy EUR/USD, you are buying EUR and selling USD.

With a 1% margin requirement, to trade 1 full size (100k) lot of USD/CHF the margin would be approximately $1,000 USD. Although the true interbank foreign exchange market does not trade in standard contract or lot sizes, retail platforms have adopted the convention of 100,000 base currency as the standard "lot" size. For pairs where the base currency is not the USD, such as EUR/USD or GBP/USD, a 1% margin requirement is determined by multiplying the current exchange rate by 100,000 and again by .01. If the EUR/USD rate is 1.2839, then the margin will be 1.2839 x 100,000 (lot size) = 128,390 x .01 =$1,283.90 USD. The formula is:

Base Currency Rate x 100,000 x .01 = Margin requirement amount in USD.
For example, AUD/USD = .7571 x 100,000 = $75,710 x .01= $757.10 margin

SAMPLE TRADE: You believe the USD has bottomed and will begin an upward trend so you decide to buy 1 lot of USD/CHF at 1.1940/42. You are buying $100,000 USD and selling $119,400 CHF. The USD/CHF moves up as expected and you close your position 3 hours later at 1.2080 or 140 pips. Essentially, by closing your position you sold $100,000 USD and bought CHF with a new rate of 1.2080 or $120,800 CHF. The difference between the new CHF rates equals the profit or loss.

Calculation: Second Currency rate - New Second Currency Rate x 100,000 or

1.1940 - 1.2080 = .014 x 100,000 = 1,400 CHF or

1,400 CHF divided by current cross rate of 1.2080 = $1,158.94 USD

Conversely, this trade could have just as easily gone against the position and resulted in a loss of $1,158.94.