Every FOREX trade involves the simultaneous buying of one currency and the selling of another currency. These two currencies are always referred to as the currency pair in a trade.
Major and Minor Currencies
The seven most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, and AUD) are called the major currencies. All other currencies are referred to as minor currencies. The most frequently traded minors are the New Zealand Dollar (NZD), the South African Rand (ZAR), and the Singapore Dollar (SGD). After that, the frequency is difficult to ascertain because of perpetually changing trade agreements in the international arena.
A cross currency is any pair in which neither currency is the U.S. Dollar. These pairs may exhibit erratic price behavior since the trader has, in effect, initiated two USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. The three most frequently traded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY.
An exotic is a currency pair in which one currency is the USD and the other is a currency from a smaller country such as the Polish Zloty. There are approximately 25 exotics that can be traded by the retail FOREX participant. Liquidity—the ability to buy and sell without substantial pip spread increases; a willing buyer or seller is always available at or near the last price—is not good. Whereas a EUR/USD pair may be traded at two pips at almost any time, the EURTRY may balloon to 30 pips or more during the Asian session.
The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215. In the FOREX markets, the U.S. Dollar is normally considered the base currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The exceptions are: the British Pound, the Euro, and the Australian Dollar. If you go long the EUR/USD, you are buying the EUR.
The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency. If you go short the EUR/USD, you are buying the USD.
A pip is the smallest unit of price for any foreign currency. Nearly all currency pairs consist of five significant digits and most pairs have the decimal pointimmediately after the first digit, that is, EUR/USD equals 1.2812. In this instance, a single pip equals the smallest change in the fourth decimal place, that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equals 1 ⁄100 of a cent. One notable exception is the USD/JPY pair where a pip equals $0.01 (one U.S. Dollar equals approximately 107.19 Japanese Yen). Pips are sometimes called points.
Just as a pip is the smallest price movement (the y-axis), a tick is the smallest interval of time (the x-axis) that occurs between two trades. When trading the most active currency pairs (such as EUR/USD or USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second. When trading a low-activity minor cross pair (such as the Mexican Peso and the Singapore Dollar), a tick may only occur once every two or three hours.
Ticks, therefore, do not occur at uniform intervals of time. Fortunately, most historical data vendors will group sequences of streaming data and calculate the open, high, low, and close over regular time intervals (1-minute, 5- minute, 30-minute, 1-hour, daily, and so forth).
Pips are a function of price; ticks are a function of time. Any location on a chart is effectively a Cartesian coordinate of Price, read vertically from bottom to top and Time, read horizontally from left to right.
When an investor opens a new margin account with a FOREX broker, he or she must deposit a minimum amount of monies with that broker. This minimum varies from broker to broker and can be as low as $100 to as high as $100,000.
Each time the trader executes a new trade, a certain percentage of the account balance in the margin account will be earmarked as the initial margin requirement for the new trade based on the underlying currency pair, its current price, and the number of units traded (called a lot). The lot size always refers to the base currency. An even lot is usually a quantity of 100,000 units, but most brokers permit investors to trade in odd lots (fractions of 100,000 units). A mini-lot is 10,000 units and a micro-lot is generally considered to be 1,000 units. A standard lot is 100,000 and a bank lot is 250,000 units.
For U.S. retail FOREX traders the minimum margin has been set by the NFA to 1 percent (100:1 leverage) for major currency pairs and 4 percent (25:1 leverage) for exotics
Leverage is the ratio of the amount used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a securitywith a comparatively small amount of capital. Leveraging varies dramatically with different brokers, ranging from 10:1 to 400:1. Leverage is frequently referred to as gearing. Typical ranges for trading are 50:1 to 100:1. The formula for calculating leverage is:
Leverage 100/Margin Percent
The most typical leverage used by traders in retail FOREX is 50:1 to 100:1. Some brokers offer up to 400:1. A new trader should start with very low leverage, perhaps 20:1 and certainly no higher than 50:1.
To some extent FOREX traders set their own leverage insofar as they determine the lot size to trade. But your broker-dealer will set a maximum
The bid is the price at which the market is prepared to buy a specific currency pair in the FOREX market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation. For example, in the quote USD/CHF 1.4527/32, the bid price is 1.4527, meaning that you can sell one U.S. Dollar for 1.4527 Swiss Francs.
The ask is the price at which the market is prepared to sell a specific currency pair in the FOREX market. At this price, the trader can buy the base currency. It is shown on the right side of the quotation. For example, in the quote USD/CHF 1.4527/32, the ask price is 1.4532, meaning that you can buy one U.S. Dollar for 1.4532 Swiss Francs. The ask price is also called the offer price.
The spread is the difference between the bid and ask price. The “big figure quote” is the dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be 117.30/117.35, but would be quoted verbally without the first three digits as “30/35.” You buy the ask and sell the bid.
TIP: Be sure you know to what accuracy your broker provides currency quotes. Many now quote in fractional (1 ⁄10) pips. This may be referred to as “Four Digit Pricing” and “Five Digit Pricing.”
Exchange rates in the FOREX market are expressed using the following format:
Base Currency/Quote Currency Bid/Ask
Plaza Accord—Devaluation of the U.S. Dollar (1985)
After the demise of all the various exchange rate regulatory mechanisms that characterized the twentieth century—that is, the Gold Standard, the Bretton Woods Standard, and the Smithsonian Agreement—the currency market was left with virtually no regulation other than the mythical ‘‘invisible hand’’ of free market capitalism, one that supposedly strived to create economic balance through supply and demand. Unfortunately, due to a number of unforeseen economic events—such as the OPEC oil crises, stagflation throughout the 1970s, and drastic changes in the U.S. Federal Reserve’s fiscal policy—supply and demand, in and of themselves, became insufficient means by which the currency markets could be regulated. A system of sorts was needed, but not one that was inflexible: Fixation of currency values to a commodity, such as gold, proved to be too rigid for economic development, as was also the notion of fixing maximum exchange rate fluctuations. The balance between structure and rigidity was one that had plagued the currency markets throughout the twentieth century, and while advancements had been made, a definitive solution was still greatly needed.
Hence, in 1985, the respective ministers of finance and central bank governors of the world’s leading economies—France, Germany, Japan, the United Kingdom, and the United States—convened in New York City, with the hopes of arranging a diplomatic agreement that would work to optimize the economic effectiveness of the foreign exchange markets. Meeting at the Plaza Hotel, the international leaders came to the following agreements regarding specific economies and the international economy as a whole:
■Across the world, inflation was at very low levels. Contrary to the stagflation of the 1970s—where inflation was high and real economic growth was low—the global economy in 1985 had done a complete 180, as inflation was now low and growth was strong.
■ While low inflation, even when coupled with robust economic growth, still allowed for low interest rates—a caveat that developing countries particularly enjoyed—there was an imminent danger of protectionist policies such as tariffs entering the economy. The United States was experiencing a large and growing current account deficit, while Japan and Germany were facing large and growing surpluses. An imbalance so fundamental in nature could create serious economic disequilibrium, which, in turn, would result in a distortion of the foreign exchange markets, and thus, the international economy as a whole.
■The results of current account imbalances, and the protectionist policies that ensued, required action. Ultimately, it was believed that the rapid acceleration in the value of the U.S. dollar, which appreciated more than 80% against the currencies of its major trading partners, was the primary culprit. The rising value of the U.S. dollar created enormous trade deficits, hurting many different economies.
At the meeting in the Plaza Hotel, the United States persuaded other attending countries to coordinate a multilateral intervention, and on September 22, 1985, the Plaza Accord was implemented. This agreement was designed to allow for a controlled decline of the dollar and the appreciation of the main anti-dollar currencies. Each country agreed to changes to their economic policies and to intervene in currency markets as necessary to weaken the value of the dollar. The United States agreed to cut its budget deficit and lower interest rates. France, the United Kingdom, Germany, and Japan agreed to raise interest rates. Germany also agreed to tax cuts, while Japan agreed to let the value of the yen ‘‘fully reflect the underlying strength of the Japanese economy.’’ However, one major problem was that not every country adhered to their pledges made under the Plaza Accord. The United States, in particular, did not follow through with its initial promise to cut the budget deficit. Japan was severely hurt by the sharp rise in the yen, as its exporters were unable to remain competitive overseas, and it is argued that this eventually triggered a 10-year recession in Japan. The United States, on the other hand, enjoyed considerable growth and price stability as a result of the agreement.
Normally only the final two digits of the bid price are shown. If the ask price is more than 100 pips above the bid price, then three digits will be displayed to the right of the slash mark (that is, EUR/CZK 32.5420/780). This only occurs when the quote currency is a weak monetary unit.
The critical characteristic of the bid-ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. In the case of the EUR/USD rate as seen earlier in Table 5.1, the transaction cost is three pips. The formula for calculating the transaction cost is: Transaction Cost Ask Price Bid Price
In FOREX you buy the ask and sell the bid. You offset a trade by closing the trade, not executing the opposite action—buy if you are short, sell if you are long.
Market-maker brokers add their profit into the spread. Electronic Communication Network brokers (ECNs) charge a small commission per lot.
Rollover is the process where the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies. Rollover cost is not significant for the short-term trader but impacts cost for the long-term trader who might hold a position for several days. If you intend to do long-term trading, be sure to shop rollover costs among several broker-dealers.