Shares Magazine
October 25, 2007
By: Marilyn McDonald
As we continue our series on the foreign exchange market, I feel that it is extremely important that you understand the fundamental concepts relating to the Spot FX market. I have been working in this industry for a little while and have seen novice traders freak themselves out over things that a more experienced trader wouldn’t bat an eyelash over. These are usually fairly minor surprises but if you don’t know they are coming, you may suffer an unnecessary blood pressure spike.
You may already be familiar with some of these concepts from other markets. For instance, there are a lot of similarities between Spread Betting and the Spot FX market, however there are also some fundamental differences.
The Pairs
Let’s start with understanding currency pairs. Currencies in the spot market are traded in pairs. You will buy one pair and simultaneously sell another, so when you buy the EUR/USD you are essentially buying Euros and selling US Dollars.
The most commonly traded currencies are called the Majors. They are the Euro/US Dollar, the US Dollar/Japanese Yen, the Pound/US Dollar and the US Dollar/ CHF or Swiss Franc. Many traders also consider the US Dollar/Canadian Dollar and the Australian Dollar/US Dollar major currencies as well.
The US Dollar
The US dollar features in many of the currency pairs that are traded worldwide. But the dollar hasn’t always been the world’s darling when it comes to reserve currencies, and there are fears that it might not be in the future. Forex traders are constantly exposed to doom and gloom tidings that seem to center around the U.S. dollar. What you need to consider is that despite the doomsday scenarios, U.S. currency has not collapsed and foreign banks, in particular Asian ones, continue to hold trillions in U.S. dollar reserves. I have heard estimates of up to two-thirds of all global central bank holdings are U.S. dollars, though official reserve holdings are allocations are not really published anywhere.
The Euro
The Euro was born on January 1, 1999, signaling the end of currencies such as the Deutsche mark, the French frank, and the Italian lira. Out of the 27 countries that make up the European Union, thirteen of them use the euro as their currency. Eleven countries initially joined to form the Eurozone – Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Greece joined in 2001and Slovenia joined in 2007. As a result the Euro has surpassed the U.S. dollar as far as total value of cash in circulation.
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.
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, the near zero inflation rate, and the historical legal requirement that at least 40 percent of the currency has been backed by gold reserves.
What Are The Most Active Times To Trade?
It is funny. I talk to traders all over the world, and they are all under the impression that the best time to trade is two in the morning. If you think about it, two a.m. can’t be the best time all over the world, can it? So when is the best time 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 its 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 activities occurs in the morning hours while the European markets are also open.
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 new date. As part of the rollover, positions are subject to a charge or credit based on interest rates of the two traded currencies with an added a markup of +/-0.25 – 0.75%. This is referred to as swap. So, if you bought a currency with a higher interest rate than the one you sold you would have a positive amount credited into your account as part of the daily roll over.
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
Remember that for some pairs the pip values are fixes and for others it fluctuates. Another thing to remember is that the date used in the calculation is always two bank days later. It works likes 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. That is why triple swaps apply to all positions that are held on Wednesdays. Swap is usually converted to your base currency at the time of calculation.
Spot the Difference
One of the fundamental differences between the spot FX market and Spread Betting is that, depending on your broker, your trade is not held at the broker but passed through to a liquidity provider. By doing this the broker is not taking a position in your trade. This means that the broker does not make any more money if you “lose” than if you “win”. This removes that ‘conflict of interest’ potential that crops up with you take a position with a market maker.
Another key benefit of trading spot FX 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 sill 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.
The last key difference we will cover is that in the spot FX 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 125 pounds and trade micro lots, which are essentially pennies. This makes testing trading strategies far less expensive that it could be plus it allows you to be a little more clinical when you are just beginning to trade. It is a lot easier to make rational decisions when you are down 50 pence rather than 50 pounds.
Marilyn McDonald is an author and foreign exchange trader. She can be reached via her website at www.marilynmcdonald.com. She is also the marketing director at Interbank FX, an off-exchange retail foreign currency broker www.interbankfx.com.