The foreign exchange market is the largest traded market in the world; however its popularity with the retail sector pales in comparison to the Equity and Fixed Income markets. This is in large part due to a general lack of awareness of FX in the investor community, along with a lack of understanding of how and why currencies move. Adding to the mystique of this market is the lack of a physical central exchange like the NYSE or the CME. It is this very lack of structure that enables the FX markets to operate on a 24-hour basis, beginning the trading day in New Zealand and continuing through the time zones.
Traditionally, access to the FX market was limited to the bank community that traded large blocks of currencies for commercial, hedging, or speculative purposes. The creation of firms like SmartTradeFX has opened the door of Forex trading to such institutions as funds and money managers, as well as to the individual retail trader. This sector of the market has grown exponentially over the past several years.
What is Foreign Exchange?
For active traders and investors, foreign exchange should be no different than other investment products such as equities, commodities or fixed-income. Because of globalization in the economic world and consolidation of whole economic regions (i.e., the European Union), including currencies in a portfolio helps to diversify assets and can reduce risk.
Just like other investment alternatives, foreign exchange offers traders/investors a market where they can buy or sell an investment product. In this case it is a specific Currency Pair. The currency pair may be the Euro versus the US Dollar, the US Dollar versus the Japanese Yen, the British Pound versus the US Dollar, the Euro versus British Pound, or a number of other currency combinations.
The different currency combinations represent nothing more than the value of one currency versus the value of another. That relationship is represented by a single price. In foreign exchange, the price of a currency pair is the market’s expectations (at that time) of the value of that currency measured against another currency given the current and expected economic and political situation in the two economies. In equity terms, it is the price of the stock.
If, for example, an economy’s inflation/interest rates are low and stable, if its output is growing strongly, or if its politics are stable and expectations are for more of the same, then one can expect (in general) for that country’s currency to remain strong versus a less fundamentally favorable currency.
Contrasting that with an equity, if the domestic and global economy is strong, if inflation is not rampant, if competition is not taking away market share or eating into margins, if product demand and growth are strong, of if the companies internal “politics” are such that the workers are happy and productive, and expectations are for more of the same, then you can expect that company’s stock to remain strong versus a company with less favorable fundamentals.
Similar to equities there are other factors that determine the short term value of a product including technical analysis, short term supply and demand, seasonal capital flow patterns, the current price of the instrument, etc. It is these universal dynamics that will move a currency’s value up or down.
The Liquid Currency Pairs
Currencies, like equities and bonds, have pairs that are very liquid and those that are not so liquid. The liquid currencies can be characterized as those that are the most stable economically and politically. They include the countries that form the G7 – the United States, Japan, Great Britain, France, Germany, Italy, and Canada.
Since the unification of the European currencies into the EURO, the currencies that are most liquid now include the US Dollar, the Japanese Yen, the British Pound, the Euro, and the Canadian Dollar. It is estimated that activities in these currencies comprise more than 80% of the daily foreign exchange volume.
Foreign Currency Symbols
Currencies, like equities, have their own symbols that distinguish one from another. Since currencies are quoted in terms of the value of one against the value of another, a currency pair includes the “name” for both currencies, separated by a “/”. The “name” is a three letter acronym. The first two letters are in most cases reserved for identification of the country. The last letter is the first letter of the unit of currency for that country.
USD = United States Dollar
GBP = Great Britain Pound
JPY = Japanese Yen
CAD = Canadian Dollar
CHF = Swiss Franc
NZD = New Zealand Dollar
AUD = Australian Dollar
NOK = Norwegian Krona
SEK = Swedish Krona
Since the European Euro has no specific country attached to it, it goes simply by the acronym EUR.
By combining one currency, EUR, with another USD, you create a currency pair EUR/USD.
The Base and Counter Currency
One currency in a currency pair is always dominant. It is called the Base Currency. The base currency is identified as the first currency in a currency pair. It also is the currency that remains constant when determining a currency pair’s price.
The Euro is the dominant base currency against all other global currencies. As a result, currency pairs against the EUR will be identified as EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD, etc. All have the EUR acronym as the first in the sequence.
The British Pound is next in the hierarchy of currency name domination. The major currency pairs versus the GBP would, therefore be identified as GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD. Apart from the EUR/GBP, expect to see GBP as the first currency in a currency pair.
The USD is the next dominant base currency. USD/CAD, USD/JPY, USD/CHF would be the normal currency pair convention for the major currencies. Since the EUR and the GBP are more dominant in terms of base currencies, the dollar is quoted as EUR/USD and GBP/USD.
Knowing the base currency is important as it determines the values of currencies (notional or real) exchanged when a foreign exchange deal is transacted.
The Counter Currency is the second currency in a Currency Pair notation.
The Value of Currencies
The base currency is ALWAYS equal to one of the currency’s monetary unit of exchange (i.e., 1 Euro, 1 Pound, and 1 Dollar). When an investor buys 100,000 EUR/USD, he is said to be buying (or receiving) the EURO or the Base Currency and selling (or paying for) the USD or Counter Currency. The amount of the Base Currency he is buying is equal to 100,000 Euros. Note that this is true no matter the current exchange rate at the time. The base currency amount remains constant.
The Counter Currency equivalent amount that the investor is selling (or paying), on the other hand, will fluctuate with the exchange rate for the Currency Pair.
It is equal to: (Amount of Base Currency x Market Foreign Exchange Rate)
Since the Counter Currency is the part of the currency pair that fluctuates higher or lower, it determines the strength or weakness of both currencies in a currency pair. As one currency goes up, the other must go down.
Currencies trade in fractions of a full unit. The smallest fraction is called a “pippet”. Currencies trade in pips because exchanges of currencies for speculative reasons are generally for large amounts. This is because of the leverage that is available when trading Foreign Exchange.
SmartTradeFX provides a Maximum Trading Leverage Ratio of 100:1for standard accounts. At that ratio, a 100,000 EUR position would require $1,200 of Margin at an exchange rate of 1.2000. This is calculated by taking the US$ equivalent of 100,000 EUR or US$140,000 and dividing by the 100:1 leverage ratio.
Margin Required = $140,000 / 100 = $1,400
To determine the value of a pip for the deal above the following calculation would be made:
Value in US$ = 1.40 x Par Amount of Base Currency = $140,000
Value in US$ + a pip = (1.40+.00010) x Par Amount of Base Currency = $120,000
The value of a pip in dollars is equal to $120,000 – $119,990 or $10.
When a currency pair goes from a low price to a higher price, the Base Currency is said to have strengthened or gotten stronger. The converse is true for the Counter Currency. That is, it has weakened or gotten weaker as the Base Currency has gotten stronger.
Since Exchange Rates represent what a fixed amount of currency is equal to in terms of another currency, we have seen there is just one price for the Currency Pair. The movement of that price determines whether a currency is getting stronger or weaker.
If the EUR/USD exchange rate goes from 1.4000 to 1.4024, we have concluded that the EUR got stronger, the USD weaker. Why?
When looking at Foreign Exchange Rates (or prices) an action to Buy the Currency Pair implies buying the Base Currency, or EUR, and selling the Counter Currency, or USD. If the EUR/USD exchange rate moves higher, as expected, the trader can now sell the EUR/USD at a dearer/higher price. The difference represents a Profit to the trader that was Long, or who bought the EUR/USD Currency Pair.
Another way of looking at it is at 1.4000, an investor/trader could exchange 1 EUR for $1.40. At 1.4100, however, that same single EUR can now be exchanged for a higher amount of USD, in this case $1.41 USD. The EUR has strengthened or gotten stronger.
Transacting Foreign Exchange Fundamentals
Buying and Selling Foreign Exchange
What exactly do you buy or sell when you make a foreign currency transaction?
In reality, you are doing both actions – buying and selling. A transaction of Buying the EUR/USD at 1.2000 is actually buying the Euro and selling the Dollars at 1.2000 cents. If the Euro increases in value in relation to the dollar, the price would increase and the investor will make money.
The Bid/Ask Price
Like equities, foreign exchange has a Bid price and an Ask price. The bid is where the market maker will buy. The ask is where the market maker will sell. For investors, the reverse is true. The bid price is where an investor can sell, while the ask is where an investor can buy.
The bid price is always less than the ask price. This makes logical sense as a market maker, like any investor, wants to buy low and sell high.
The spread between the bid and the ask is called the Bid/Ask Spread. The bid/ask spread is the premium that market makers charge to provide constant liquidity to a retail client base. For example, the bid and ask might be 1.2050/1.2055. The spread is 5 pips.
Paralleling foreign exchange trading to equities, SmartTradeFX plays the role of an ECN, where all orders are routed to the interbank market.
Unlike a market maker, we do not trade against our client. This allows us to save on overhead, and keep the spread as low as possible. Since we provide you with actual quotes from the interbank, the spread on liquid pairs can sometimes be as low as 0 PIPS.
Obviously, if the volatility increases because the markets become less liquid, it stands to reason that our spreads will increase as well. These are universal realities of trading and should not come as a surprise to knowing investors/traders.