Forex Trading by Money Market, BNG

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Study Material for Forex Trading

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Forex
1. The Origins
The FOREX (FOReign EXchange) Market is a cash-bank market established in 1971 when the US
went off the gold standard adopted in the 1930's. At that time the US had to drop the gold standard after the
1929 crash and the British Pound became the currency of choice and the world's currency.
There have been other times before in Western History when paper money could be exchanged for
gold. Throughout most of the 19th century and up to the outbreak of WW1, the world was on so-called
"Classical Gold Standard" with all major countries participating in it. A gold standard meant that the value of a
local currency was fixed at a set exchange rate to gold ounces. This allowed unrestricted capital mobility as
well as global stability in currencies and trade
The participating countries were required to observe some rules: for example, it was particularly
important that no country would impose restrictions on the importation or exportation of gold as a
commodity nor a payment method. This was a guarantee for a free capital mobility based on supply and
demand conditions.
Under this model, in which most central banks backed their paper money with gold, the currencies were
supposed to enter in a new phase of stability, without the danger of an arbitrary manipulation of its value to
increase inflation.
During the interwar period the world powers tried to return to the gold standard at the
exchange rates previous to 1914, which seemed to offer prosperity and stability, but the attempt did not
succeed and exchange rates ended mostly floating. The classical gold standard was shattered by the outbreak
end of WWI and collapsed under its violence. Private trade and financial transactions were suspended, gold
exports were banned, and each country started to print money to finance the war effort. The 1920s-30s
were characterized by recessions and the Great Depression. There was a hegemonic power shift from the
UK to the US.
After WWII the system became a US-centered fixed rates under a new international gold standard
and the world economy experienced high growth, price stability and movement toward freer trade. Unlike
the classical gold standard days, however, there were severe restrictions on private capital mobility.
The gold standard had its inefficiencies the way it was handled: the combination of a greater
supply of paper money without the gold to back it led to devastating inflation and resulted in
political instability.
The problem with gold is that its quantity is too constraining: the world supply of gold was
insufficient to make the Bretton Woods system workable -particularly as the use of the Dollar as a reserve
currency was essential to create the required international liquidity to sustain world trade and growth. As
economies grew stronger and needed more money to pay imported goods, there was no sufficient gold
Forex
reserves to pay for it. As a result the monetary mass decreased, the interest rates increased and the economic
activity slowed down and the economy entered in a recession.
In such cases, the low prices of manufactured goods were then attractive for other nations. These started to
import massively and by doing so they contributed to the increase of the monetary mass in the exporting
country. This, in turn, allowed to ease the interest rates and subsequently the economy to grow. It was
evident that the mechanism linking inflation/deflation with gold flows was not able to adjust macroeconomic
imbalances. It was thought that under a gold standard, a country with a current account deficit would imply an
outflow of gold. The loss of gold means less money supply, so the country would experience a price deflation.
This would make its goods become cheaper in the global markets, making imports rise and exports fall,
improving the current account again.
These peak-bottom periods alternated until the WWI interrupted the commercial flow and the
gold exchange. Until WWII, currency speculation was almost inexistent and even not very much favored by
institutions. The Great Depression and the abolition of the gold standard in 1931 led to a pause in the
exchange activity. But later, after the transition period of 1971-73, the market suffered a series of changes
which shaped the actual global monetary system: the major currencies started to float.
The Bretton Woods Regime, the Transition Era

After WWII the world needed a stable currency and a monetary agreement was reached by July
1944: seven hundred and thirty delegates from forty-four allied nations came together in Bretton Woods, NH,
US The reason for the gathering was the United Nations Monetary and Financial Conference. For the first
time in history monetary relations amongst the world's major industrial states were governed; it was the first
time a system was implemented, in which the rules for commercial and financial relations were negotiated
and agreed upon.
It is said that many political reasons ended up resulting in the Bretton Woods agreement. Just to
name a few: the two world wars and the interwar years, which was followed by the need to rebuild
international economy; the Great Depression; the strong and shared belief in capitalism; USA.'s status of
dominant power; the need for an economic system that would act as security.
Pegged, Semi-Pegged And Floating Condition

Considering the outcome of floating rates in the 1930's, which had negative worldwide
consequences, the participants of the conference were eager to adopt basic rules with which to regulate the
international monetary system as well as to create a policy in which the exchange rate of each currency would
have a fixed value.
And indeed such measures were implemented: new international institutions were established to promote
foreign trade and to maintain the monetary stability of the global economy.
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Forex
The Bretton Woods system was an effective system that controlled conflict for many years. It
could achieve the common goals that were set, however, its lifespan was finally short as by 1971 it
collapsed.
It was also agreed that currencies would once again be fixed, or pegged, but this time to the US
Dollar, which in turn was pegged to gold at 35 USD per fine ounces of gold. This meant that the value of
a currency was directly linked to the value of the US Dollar. At that time if you needed to buy British
Pounds, the value of the Pound would be expressed in US Dollars, whose value in turn was determined
by the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF
to change the pegged value of its currency.
The peg was maintained until 1971 when the US Dollar could no longer hold the value of the pegged
rate. From then on major governments adopted a floating system and all attempts from major economies
to move back to a peg were eventually abandoned.
The Bretton Woods agreement was also meant to accomplish several other purposes: to avoid the
capital evasion between nations, to restrict speculation with currencies, and to prevent each country from
pursuing selfish policies, such as competitive devaluation, protectionism and forming trade blocks More
generally speaking, to create a new world economic order. In fact, this new model brought two main
advantages to the US: in on hand the revenues from the money creation itself called seigniorage and on the
other hand the possibility to hold a trade deficit for a very long time.
John Maynard Keynes, chairman of the Bank Commission at the Bretton Woods conference, and
one of its intellectual founding fathers, envisaged an international monetary clearing union that in
reality would have been a world central bank creating and using a world currency he called
'bancor'.
The problem, as Keynes well understood, was that an international trade and payments system -
that relied on flexible exchange rates system with multiple currencies - would be inherently unstable. Keynes'
proposal for a clearing union would penalize both deficit and surplus countries. Each country would have an
official account in this mechanism, and all balance of payments surpluses and deficits would be recorded and
settled through these accounts. There would be an incentive for both types of economies to run balanced
trading systems as each country would bear the responsibility for correcting its imbalance. This truly
visionary proposal to create a mighty settlement union for all countries was seen as negative from US point of
view.
Keynes' plan was not fully adopted but, in recognition of the pragmatic validity of his proposed
solution, the exchange rates were fixed relative to the US Dollar and the Dollar backed by gold reserves. All
other currencies could
not deviate more than 10% to both sides of the fixed rate.
The US proposal, which was finally adopted, meant that each country would contribute to a
common fund and member countries with surplus or deficit imbalances would have to purchase hard
currencies from this fund. At the time, the UK was a deficit country and the US a surplus country, and only
deficit countries would bear the responsibility for correcting the imbalance.
Forex
In case of such a fundamental imbalance, the central bank responsible of the currency had to ask
authorization to the International Monetary Fund (IMF) to bring the value of its currency back to accepted
levels. The IMF and what has evolved to be today the World Bank, the International Bank for Reconstruction
and Development, emerged at that time to administer the new system.
At this point let's summarize the main features of the Bretton Woods system:
It's a Dollar-based world payments arrangement: officially, the Bretton Woods system was a gold-
based system which worked symmetrically for all countries. But in reality, it was a US-dominated system,
which means the US provided domestic price stability (or instability) that other countries could (or should)
"import". As the US did not itself engage in exchange rates intervention, which would have been desirable, all
other countries had the obligation to intervene themselves in the currency market to fix their exchange rates
against the US Dollar.
It was a semi-pegged exchange rate system: this means that exchange rates were normally fixed
but permitted to be infrequently adjusted under certain conditions. Members were obligated to declare a par
value (a 'peg') for their national currency and to intervene in currency markets to limit exchange rate
fluctuations within maximum 'band' of one per cent above or below parity. At the same time, members also
retained the right, whenever necessary and in accordance with agreed procedures, to alter their peg to
correct a 'fundamental disequilibrium' in their balance of payments. This arrangement was thought to
combine exchange rate stability and flexibility, while avoiding mutually destructive devaluation.
Tight capital mobility: by contrast to the classical gold standard of 1879-1914, when there was free
capital mobility, member countries could impose capital-account regulations and severe exchange controls.
Macroeconomic growth reached historically unprecedented highs: this was achieved through global price
stability and trade liberalization from the mid 1950s to the late 1960s.
The expansion of international trade and the massive capital movements led to a Dollar
shortage.
Later, during the 50's, the Bretton Woods system was under enormous pressure and needed help
to function properly when the major economies started to evolve in different directions. While the classical
gold standard collapsed because of external forces (the outbreak of WWI), the Bretton Woods regime failed
due to internal inconsistency. US monetary policy was the system's anchor and the growing inflation in the US
destabilized the system until it started to disintegrate.
After WWII, Europe and Japan needed to import from US all kinds of manufactured goods and
machinery for its own reconstruction while US wanted to favor Western European countries in front of the
menace of Eastern European countries and the USSR. But there were not enough Dollars in circulation. So in
1948 the US decided to give west Europe an economic aid, under the name of the Marshal Plan, officially
called the European Recovery Program.
In the 60's the situation started to revert and an oversupply of Dollars in circulation gradually
Forex
appears. The Vietnam war, welfare expenditure and the space race with the USSR were the major reasons
for the increased US government spending. When US inflation began to accelerate, other countries refused
to import it into their economies. This whole situation destabilized the exchange rates agreed upon in
Bretton Woods.
Shortage in international currencies and abundance of US Dollars rise some doubts about its convertibility to
gold. The already high trade deficit of the US led to speculative pressures awaiting a strong devaluation of the
US Dollar versus gold. A series of readjustments held the system for a while but finally, on August 15, 1971,
everything changed. US President Nixon suspended the gold convertibility standard and in 1973 the US
formally announced the permanent floating of the US Dollar, thereby officially ending the fixed exchange rate
regime and the Bretton Woods system.
The system became an open US-Dollar-based world payments arrangement.
Let's define some of the concepts that we have learned so far:

What is an exchange rate? An exchange rate is the rate at which one currency can be exchanged
for another. In other words, it is the value of one country's currency compared to that of another. When
traveling abroad you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the
price at which you can buy that currency.
For instance, if you are a European wanting to travel to the US and the exchange rate for EUR 1.00 is USD
1.50 this means that for every Euro, you can buy one and a half US Dollar.
You have also seen that there are different ways the price of a currency can be determined against another:
Through a fixed, or pegged, rate which is a rate the central bank sets and maintains as the official
exchange rate. In this case a set price will be determined against a major world currency (usually the US
Dollar, but also other major currencies such as the Euro, the Yen, or a basket of currencies). In order to
maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange
market in return of the currency to which it is pegged. To do this, the central bank must keep enough foreign
reserves to release or absorb into or out of the market.
Some governments may also choose to have a semi-peg whereby the government periodically
reassesses the value of the peg and then changes the peg rate accordingly. Usually the change is devaluation
but one that is controlled so that market panic is avoided. This method is often used in the transition from a
peg to a floating regime.
Although the peg has worked in creating global trade and monetary stability, it was only used at a
time when all the major economies were a part of it.
And while a floating regime has its flaws, it has proven to be an efficient means of determining the
long term value of a currency and creating equilibrium in the international market.
Forex
You may now ask: "Why the need to fix a currency?" It has to do with the aim to create a stable
atmosphere for foreign investment, specially among developing nations. If the currency is pegged, the
investor will always know what its value is and will not fear hyperinflation. However the peril exists that such
countries experience financial crisis as well, like Mexico in 1995 and Russia in 1997.
An attempt to maintain a high value of the local currency to the peg can result in the currencies eventually
becoming overvalued. This means that the governments could no longer meet the demands to convert the
local currency into the foreign currency at the pegged rate. With speculation and panic, investors would start
to convert their currency into foreign currency before the local currency is devalued against the peg,
depleting the central bank's foreign reserves.
There is also a floating condition, which allows the Forex market to function as we know it
nowadays with most of the major currencies. A floating exchange rate is determined by the private market
through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and
demand will automatically be corrected in the market.
A floating exchange rate is constantly changing as a decrease in demand for a currency will lower its
value in the market. This in turn will make imported goods more expensive and stimulate demand for local
goods and services. As a consequence, more jobs are created, and hence an auto-correction occurs in the
market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid
inflation; however, compared with a fixed system, it is less frequent that the central bank of a floating regime
interferes.
A country can also opt to implement a dual or multiple foreign exchange rate system, where both
modalities run in parallel. Unlike a pegged or floating system, the dual and multiple systems consist of
different rates, fixed and floating, running at the same time. The fixed rate is usually a preferential rate and the
floating a more discouraging one.
While the fixed rate is only applied to certain segments of the market, like the import/export of
essential goods, the floating rate is set by the forces of supply and demand in the market and is applied to non-
essential goods like luxury imports.
This system is also usual in transitional periods as a means by which governments can quickly implement
control over foreign currency transactions. In those cases, instead of depleting its foreign reserves, the
government diverts the heavy demand for foreign currency to the free-floating exchange rate market.
As with the other solutions, a multiple exchange rates system is not free from negative consequences:
creating artificial conditions for certain market segments is one of them. But it could also be used as an
effective means to address the problem in the balance of payments developed under the conditions of a
completely free floating system.
Note that none of these systems are perfect, but that all are thought as mechanisms to deal with
those underlying problems in economic crisis and inflation periods. Their aim is to eventually keep
the equilibrium in the monetary system.
Just to summarize, these are the four exchange rate systems, or regimes:
Forex
Pegged exchange rate system: the value of the currency is tied to another currency, to a basket of
currencies or to the price of gold. The purpose of a fixed exchange rate system is to maintain a country's
currency value within a very narrow band.
Semi-pegged exchange rate system: the central bank periodically readjusts the fixed (pegged) value of
its currency.
Floating exchange rate system: the value of a currency changes freely and is determined by supply and
demand in the Forex market.
Multiple exchange rate system: both systems are simultaneously used in different segments of the economy.
2. Good Buy Bye Gold?

The most fundamental answer why gold was needed to establish an international monetary system is
perhaps that even fluctuations in the value of money caused by the supply and demand of gold are better than
experimenting hyperinflation or deep devaluation because of irresponsible monetary policy.
But history shows that there were serious problems associated with the gold-money peg and that it
was impossible to keep the linkage. Difficulties arrived when the supply of gold oscillated, causing short term
price fluctuations. Moreover, the rapid growth of the world economy was faster than the supply of new gold,
and a long term shortage of gold became a constraint to maintain the peg.
The abandonment of the convertibility to gold was the start of the Forex market. The US Dollar,
already under serious pressure due to the US trade deficit, was allowed to float and all currencies were set
adrift to find their place in the global economy. From there on many speculative opportunities started to
afloat.
Since the early 70's the major world currencies started to float freely, mainly controlled by offer and
demand on the exchange market, and has kept floating for almost 4 decades now. Among these currencies,
there were the Deutsche Mark, the British Pound and the Yen, and their prices were calculated on a daily
basis. The volumes, velocity and volatility started to increase and new financial instruments were created.
Since then, exchange rate instability among major currencies has been the norm.
The Transformation Of Currency Exchange In The '70s

The following decades saw the FOREX being transformed by far in the largest and less regulated
financial market in the world thus abolishing restrictions on capital flows in almost all countries, and allowing
market forces to move exchange rates.
But the idea to fix exchange rates did not disappear. Some major economies attempted to move back
to a peg or valuate currencies relatively to something: it happened during the 70's and 80's when Asian
communities tried to group together as the west Europeans did. During these years currencies exhibited
short-term volatility, medium-term misalignment and long-term drift. While after the breakdown of Bretton
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Woods the majority of policy makers thought the free floating system had an automatic adjusting
mechanism, the fact was that exchange rate instability itself became a serious threat to the world economy.
In December 1971, there was an international effort to re-establish the fixed exchange rate system at
adjusted levels: the monetary authorities of major countries gathered in Washington, DC to set their mutual
exchange rates at new levels and the Smithsonian Agreement is signed, similar to the previous Bretton
Woods, but allowing higher foreign exchange fluctuations.
In 1972, the European Community, in an attempt to gain independence from the influence of the Dollar,
created the European Joint Float formed by the German Federal Republic, France, Italy, Holland, Belgium and
Luxembourg. This was another initiative to revise and redesign the international monetary system. However
the agreement is abolished a year later and a shift to a floating rate system occurred by default, since there
was no alternative agreement at the time. As a result, new markets emerged along with new financial
instruments, market deregulation, market systems and trade liberalization.
Governments could thereafter set semi-pegged or leave their currencies fluctuate freely. In fact,
in 1978, the free floating system is installed between the main industrialized countries, which
meant, once again, that the relative value of currencies would be determined by the forces of
supply and demand.
One of the major catalysts for the acceleration of currency exchange was the rapid increase in US
Dollar deposits in banks outside the control of US authorities. Revenues from Russian oil sales, for example,
were deposited in Dollars, but out off of the United States, due to the fear of being frozen by the regulatory
authorities of the United States.
The US government imposed laws to restrict Dollar lending to foreigners. Euromarkets were particularly
attractive because they had far fewer regulations and offered higher yields. The US government restricted
lending Dollars to foreigners in response to the explosive growth in the number and size of deposits abroad.
This was a precursor of the Eurodollar market (a market where assets are deposited in a currency
different from the currency of origin). Later in 1978 Europe created the European Monetary System, based
on the Eurodollar market which first emerged in the 50's.
Within this context, and because of its convenient location - which permits to operate simultaneously
with the Asian and American markets - and its ability to connect these two markets, London became, and still
remains, the world capital of the foreign exchange market.
In the 80's it became the key center of the Eurodollar market when British banks began
lending Dollars as an alternative to Pounds in order to maintain its leadership position in global finance.
Until 1985, the Dollar gradually appreciated damaging the international competitiveness of US firms.
In September 1985, the Plaza Agreement was signed between the G5 countries (US, Japan, Germany,
France, UK) to lower the US Dollar which was clearly overvalued.
The joint intervention of the G5 was very effective, however, the US Dollar continued to lose ground
beyond acceptable levels for Japan and Germany. In February 1987, the economic leaders of the G7 countries
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(G5 plus Italy and Canada) met in Paris to stop the further fall of the Dollar, known as the "Louvre
Accord". This cooperation era was about managing free floating exchange rates through coordinated
interventions.
 Did you know that the Pound is also called Clabe" in FX jargon because of the cable connection across
the Atlantic Ocean, connecting London and New York?
From the late 80's onwards US companies began to borrow foreign currencies, finding in the
Euromarkets an attractive investment opportunity where to channel their excess of liquidity, and a source of
short-term financing for foreign trade.
This movement of capital across borders skyrocketed foreign exchange transactions to about US$ 70 million
a day in the early 80's with the development of computational tools. These tools accelerated the international
flow of capital, bringing the market spread throughout Asia, Europe and America. These same tools allowed
the participation of private investors in a market that was traditionally the exclusive domain of banks and large
institutions.
In 1991 the Maastricht treaty was signed. It was meant to converge the exchange rates, inflation and
fiscal balance between several European currencies. However, the unification of West and East Germany
conducted at a 1 to 1 exchange rate, put an upward pressure on the Deutsche Mark which was the anchor
currency for the future Euro. This put a downward pressure on other currencies, the British Pound started to
fall and England abandoned the group, unwilling to import high interest rates from Germany. In 1992-93 the
European monetary system almost collapsed when economic pressures were threatening with aweaker
currency devaluation.
But the pursuit of monetary stability in Europe, which started in Europe in the 1970s,
continued with a renewed attempt not only to fix the European currencies, but also to replace them with a
single currency. Finally, in 2001, the project to establish a regionally common currency completed and the
Euro surged stronger against the US Dollar.
Speculative turnovers in currency exchange

The volume traded in Forex today is so high that no data is available, but every three years, the BIS (Bank
of International Settlements) publishes the results of a survey made among major market participants and
creates an estimate based on the responses obtained.
Forex
Source: Bank For International Settlements
The above graphic, excerpted from The Triennial Central Bank Survey of Foreign Exchange and
Derivatives Market Activity, shows volume growth in the last years.
The most recent report, completed in 2007, estimated the average global daily volume at about 3.2
trillion traded in the world's main financial markets, of which an estimated 95% is speculative. Its daily
transaction volume is about 100 times that of all the stock-exchanges together. The fact that 95% of the
market is speculative means that most of the participants buying a currency really have no intention of
receiving that particular currency. They're watching their price movement to sell it back for a profit when it
has increased in value.
The other 5% of the daily turnover come from companies hedging their exposures and
governments exchanging foreign currencies and reserves.
85% of the turnover is done in the major currencies against the Dollar where there is the most
important liquidity, allowing fast fills in and out of the market. You can find just above a link to a table
excerpted from the last Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity of
2007.
In the most recent results in which the BIS classifies exchange volume by country, London remains the
capital of the FOREX market. The EUR/USD pair is the most traded, and it is not a coincidence that the pair
has the lowest spreads - the width between bid and offer price. Generally, in the interbank market, the higher
the volume, the lower the spreads are.
Forex
In the next chapters you will learn what spreads are and all about the market mechanics, but for now
we will show you how this market is composed and who moves and shakes it!
Scott Owens introduces the Forex by explaining:
Since currencies are valued differently, there is a market in place to set those values. Where a market
exists speculation inevitably follows. In this case, the market is hyper-active. Banks sending deposits around
the world, corporations hedging their exposure to currency risk in different countries, government banks
forwarding national economic goals through monetary policy, and massive investment funds playing the role
of speculator. Not long ago, that was the extent of the market. It was the domain of the professional trader or
banker.
The word "market" usually invokes the idea of a central market place like the New York or London
exchanges. This is not the case in forex. Instead, forex functions through what is known as the "interbank"
market. Interbank is a fancy way of saying that banks trade with each other, absent a central market place.
This is one major reason why volume data is not available for forex. It's also the reason why retail investors
and smaller traders were left on the sideline for so long.
In the 90's, a series of events unfolded that made forex available to retail investors. Deregulation led
many companies to form pools of liquidity where retail investors could take advantage of the huge speculative
opportunity in forex. These dealers offered high leverage, low minimums, and a new way to trade - 24/7.
3. The Market Structure
Although we track the start of the Forex in the early 70's, the lack of a central marketplace for
transacting foreign exchange made difficult for importers and exporters to accurately track daily movements
in the currencies. In fact they had no prior experience with floating exchange rates and therefore no in-house
expertise. They were at the mercy of the banking industry, specially the big banks for whom foreign exchange
became a huge source of revenue.
The first foreign exchange brokers came on stage in the mid 70's to offset a significant customer
foreign exchange business for medium and small banks, which needed continuous exchange rates in the
major currencies.
Initially the foreign exchange brokers installed direct lines to all the banks willing to participate.
Generally a major bank made a rate and the brokers showed the rate to all the banks at about the same time.
The first bank to deal on the rate completed a transaction. The others waited for the next rate. Any bank
could make a rate; show a bid or an offer. Soon, with the aid of new technologies, the brokers became quite
sophisticated and efficient at putting together a continuous two-way price and using the banks as their
primary liquidity providers.
Forex
The Interbank Market
When speaking of Forex at a governmental level (central banks) and institutional level (commercial
and investment banks), we refer to a market which, nowadays, negotiates over 3 trillion Dollars a day. At this
level, exchanges of 5 to 10 million are frequent, but also amounts of 100 to 500 million are traded between
major participants.
It's an interbank or over the counter market (OTC) and spot market, meaning it is not done
through an exchange. Unlike most other exchanges, the Forex market is not a centralized market
where each transaction is recorded by price dealt and volume traded. There is no central place
back to which all trades can be traced and there is not one market maker but many.
Each market maker records his or her own transactions and keeps it as proprietary information. The primary
market makers who make bid and ask spreads in the currency market are the largest banks in the world. That
literally means banks constantly dealing with each other either on behalf of themselves or their customers.
This is why the market on which banks conduct transactions is called the interbank market.
Larger speculators also operate in the interbank market where they can execute multi-million Dollar
trades with ease.
Individual traders, who generally trade in much smaller sizes, primarily do so through brokers and
dealers.
The volume negotiated is particularly focused in London, but also in New York and Tokyo. These
cities are also major trading and decision centers for monetary matters because of their sheer size
in turnover and number market participants also because the happenings in these places tend to
influence other dealing centers around the world. Other important locations at this level are
Sydney, Switzerland, Frankfurt, Singapore and Hong Kong.
Many of today's major currencies fluctuate freely between each others and are negotiable virtually
throughout the world. This has resulted in increased speculation by banks, hedge funds, brokers and
individuals. Central banks occasionally intervene with the intention to move the currency towards desired
levels, however, the underlying factor that leads the Forex market are the forces of supply and demand.
The lack of physical change enables the exchange market to operate 24 hours a day, 5 days a week,
covering different areas across the most important financial centers. Its tremendous volume of transaction
makes it very liquid and therefore highly desirable to trade. Currencies are the most traded assets in the
world - any commercial or financial flow across borders may involve a currency exchange.
Until the popularization of Internet trading, FX was primarily the domain of government central
banks and commercial and investment banks. With the increasingly widespread availability of electronic
trading networks and matching systems, trading on the foreign exchange is now more accessible than ever.
Forex
The market has been rendered feasible to non-banking international corporations like hedge funds,
which can now trade via intermediaries thanks to those networks. They are the high level that really moves
the currency market buying or selling huge amounts in the mid to long term: their time frame is generally
weeks to months, possibly years. Their transactions unbalance the market, requiring price adjustment to
rebalance demand and supply.
The volume negotiated is particularly focused in London, but also in New York and Tokyo. These
cities are also major trading and decision centers for monetary matters. Other important
locations at this level are Sydney, Switzerland, Frankfurt, Singapore and Hong Kong.
The presence of such heavy weight entities may appear rather discouraging to any aspiring trader. But the fact
is that the presence of such powerful entities and their massive volume in transactions can also work to your
benefit as a trader.
It is important to note that even high-level financial institutions are vulnerable to market movements and are
also subject to market volatility as all the other smaller participants. In practical terms, this means that the
market is too big for a single participant to control it and that the alleged insider information that large banks
have is of very relative value compared to the size of the market.
Individual traders, in turn, do not move the currency market so much. Their time frame is usually
much shorter and so is their investment horizon. Therefore they do not impact the demand/supply
equilibrium in the aggregate in the same way, nor their positions have a lasting effect on the currency prices.
But on the other hand, their trading models and lower volumes allow more flexibility to enter and exit the
market.
At this point it's interesting to note that the trading activity of each financial center will determine the
behavior of the market. Thus when the London markets open and the session starts, it's still overlapped with
the last two hours of activity in Tokyo. Position openings done by London traders and the closure of positions
in Tokyo coinciding in a interval of two hours may explain the increase in activity and volatility around this
time. Later the European and the US session match during 4 hours in a combination of players, significantly
increasing liquidity.
It's worth mentioning the importance for the retail trader to be aware of the most recent leading
center's trading activity. This applies not only to market activity, such as the announcement of economic data,
but also inactivity. So if these centers are together or separately on holiday, do not be surprised when trading
tends to go quiet. Hence it's a good idea to check a calendar of major international holidays when doing your
market research and planning particular trades. Any readings of a sudden movement during an otherwise less
active period can point to a false alarm. Perhaps it's just one large participant, such as a hedge fund, who has
made a big transaction. Not finding much volume, the market records the hedge fund's transaction as a spike
out of previous price ranges.
Forex
4. Traded Instruments
The trading departments in larger banks consider various factors when determining exchange rates:
besides taking into account their inventory positions, they also watch for volumes and recent price action and
apply their particular analysis to see where each currency is headed. Usually they will quote more favorable
rates to their counter-parties in the opposite direction they think the price is going for any particular
currency.
They do this trading several Forex financial instruments. A financial instrument is a medium which can
be traded, commonly categorized into two categories: cash instruments and derivative instruments. The first
being such financial instruments like securities, loans, and deposits. These are readily transferable and their
value is determined directly by the market. And the later, the derivatives, can be divided into two further
categories: over the counter (OTC) derivatives and exchange-traded derivatives.
Foreign Exchange instruments and transactions have their own category in which: standard derivatives are
Foreign Exchange futures; main OTC derivatives are Foreign exchange options, forwards and swaps; and
cash instruments is the spot.
Many folks tend to think strictly of the spot market, but it is not the only one. An array of other investment
vehicles have been popping up in the Forex world, providing traders even more ways to take positions in this
market. These are the most traded ones:
Outright Forwards
In the case of forwards it is a transaction in which money does not actually change hands until a specific
(and a previously agreed-upon) future date. In this case, the exchange rate is one which the buyer and the
seller have agreed upon any future date, and it is not necessarily based on current market rates, and the
transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can
be a few days, months or years.
The most common type of a foreign exchange forwards transaction is a currency swap. At the end of which
the transaction is reversed. Currency swap is not traded via an exchange.
Futures
The currency futures are transactions with standard contract sizes and a maturity date (usually of
three months). Futures are standardized and are usually traded via an exchange created for this purpose and
usually include an interest amount. The futures market has become a bit more attractive for small speculators
with the expansion of e-mini currency contracts.
It should also be noted that although some folks will claim there is no rollover in forex futures, the
interest rate spread is definitely factored in. You can see this when comparing the futures prices with the spot
market rates. As the futures contracts approach their delivery date their prices will converge with the spot
rate so that the holders will pay or receive the differential just as if they had been in a spot position.
Forex
Currency Options/Warrants
A foreign exchange option is another Forex instrument belonging to the derivatives, where the
owner has the right but not the obligation to exchange money denominated in one currency into another
currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and
most liquid market for options of any kind in the world.
Currency Swaps
Contract which commits two counter parties to exchange streams of interest payments in different
currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-
agreed exchange rate at maturity.
ETFs
Among the Forex instruments you can also find the exchange traded funds (ETFs) typically traded on
an exchange as baskets of securities with an underlying index. ETFs are open ended investment companies
that can be traded now replicating investments in the currency markets. These funds track the price
movements of world currencies versus the US dollar, and increase in value directly counter to the US dollar,
allowing for speculation.
As an investment, currency ETFs closely resemble savings accounts; the ETFs hold cash and
invest it with banks to get interest. So when measured in the appropriate foreign currency, your shares are
unlikely to gain or lose much value -- a share worth 100 Euro now will probably be worth 100 Euro next
month or 10 years from now. Each deposit account will pay slightly less than the currency overnight interest
rate, and is subject to fund expenses.
Spot
Finally, the currency spot, the instrument most covered in the Education Center: In the spot market
currencies are sold for cash and delivered immediately and prices reflect what one currency is currently
worth in terms of another currency. In the most cases it's technically a two-day "maturity" transaction, in
which two currencies are traded with cash (rather than a contract). Spot has the second largest share by
volume in FX transactions among all instruments accounting for an average daily turnover of 1.005 trillion.
The spot is traded over-the-counter, meaning it is traded through a dealer network and not through an
exchange.
There are many currencies traded on a day-to-day basis on the spot market. You will notice that is
always a currency moving up or down. From a price-action perspective, currencies rarely spend much time in
tight trading ranges and tend to develop strong trends. Remember, most of the currency trading volume is
speculative in nature and, as a result, the market frequently overshoots and then corrects.
This volatility will assure endless short-term and long-term cashing opportunities, allowing you to profit in
Forex
both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements
relative to equity markets. We will cautiously consider all the so-called "advantages" of currency trading in
more detail below.
Many of the instruments utilized in Forex will appear similar to those used in the equity markets. Since
the instruments on the Forex often maintain minimum trade sizes in terms of the base currencies (the spot
market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin
is absolutely essential for the person trading these instruments. You will learn more about this intricacies in
the next chapter.
The growth in retail Forex has been very rapid, especially as equity and futures traders realized the
approaches they've been using for years in their respective markets, particularly price-based techniques
based on technical and quantitative analysis are equally applicable to Forex.
5. Advantages and Disadvantages

There are some significant differences between Forex and other markets like the equity markets or
futures. While a good trader may be able to handle any market, structural differences in Forex can force a
different approach. Moreover many of the so called "advantages" bring some inherent risks with them.
Not Regulated
The global nature of the interbank market, without an unified or centrally cleared market for the
majority of FX trades, make difficult to apply a cross-border regulation.
Central banks such as the Federal Reserve Bank of the US or the European Central Bank provide to some
degree oversight. But in general, the currency markets are much more lightly regulated than equity or bond
markets.
There are, nevertheless, several associations and institutions which supervise and regulate key
players at a national level. We will cover these subject in the next chapter.
No Exchanges
While it is true that there is exchange-based Forex trading in the form of futures, the opposite
condition occurs in the OTC market via the spot market.
Trading in a decentralized environment may be seen as having advantages or not:
In a decentralized market, trading does not take place on a regulated exchange. It is not controlled by
any central governing body, there are no structured clearing houses to guarantee the trades and there is no
arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements.
Essentially, business in the largest and most liquid market in the world depends on the so called "margin"
accounts, a concept similar to good faith deposits. This fact can be considered as a disadvantage, while the
lack of clearing fees or other exchange fees can be seen as an advantage. Most brokers don't make you pay
fees to maintain an account regardless of your account balance or trading volume.
Forex
Besides, the lack of an exchange means a difference in how the exchange is actually done. In spot
Forex much of the trading done by individuals is actually directly executed with their broker/dealer. That
means the broker takes the other side of the trade. This is not always the case but it is the most common
approach.
This doesn't mean the broker is deliberately trading against you - he still has to offset his risk in the
overall market. We will talk extensively on false and true myths about brokers in the next chapter.
In a centralized market, you have the benefit of seeing real volume information, for example, and you
might find comfort in knowing that there is a regulated mechanism backing your market participation.
Besides, the lack of a centralized exchange can lead to a discrepancy among price information from one
market maker to the next, leading to the possibility of unfair trading activities.
At first glance, this ad-hoc arrangement can look like the wild west to investors who are used to
organized exchanges. But be reassured, this arrangement works exceedingly well in practice: because
participants in Forex must both compete and cooperate with each others, self regulation provides very
effective control over the market.
Furthermore, reputable retail Forex broker/dealers in many countries are supervised by their
national financial authorities, and agree to binding arbitration in the event of any dispute. Therefore, it is
critical that any retail customer who contemplates trading currencies do so only through a regulated firm.
We will extensively talk about broker/dealers in the next chapter and how to inform and protect
yourself.
Instantaneous Order Execution and Market Transparency

In the Forex world, fast order execution and instant fill confirmation is usually routine because you'll
be trading via an Internet-based platform. Market transparency is highly desired in any trading environment.
With no exchanges, there are no traditional open-outcry pits, no floor brokers and, consequently, no delays.
Obviously, you might have to absorb some slippage if you trade during news announcements or if you trade a
high volume, but normally all the prices on your broker platform are executable and your profit potential is
not compromised.
Given the multi million-Dollar exchange that takes place every day in the currency markets, manipulation
of the price is rather inexistent compared to other less liquid markets. However combined actions may
occur in which several of the major participants - like central banks - force the market in a certain
direction. That being said, this is not a rule but rather an exception.
In this regard, you should be informed of the market hours that tend to be more or less liquid as well as of
the dates and times of the year in which the major trading places are less active. During low liquidity
times the market is more vulnerable to erratic volatility or manipulation, like during the Asian session, or
during longer periods such as holiday seasons.
Forex
In the stock market there are restrictions imposed on selling short that you don't have in the Forex. It is
just as easy to take a short position as it is to take a long one. In chapter 3 you will learn the mechanics to
trading.
24-Hour Trading
The Forex is the only market which can truly be viewed as a 24-hour market, which is one of the
notorious differences you will notice if you came from another market. There is trading activity in all time
zones during the week, and sometimes even on the weekends as well. In other markets traders must wait
until the market opens the following day in order to open a new position.
However each hour of the day has a certain level of liquidity and each currency is associated with the
trading session normally corresponding to its time zone and business hours. The Yen, for example, may show
a greater liquidity during the Asian session. In contrast, a currency outside of its normal business hours can
display more erratic movements in a chart.
A market operating 24 hours is surely attractive but you can easily fall into overtrading, taking far too
many trades. Exercising some discipline will help you avoid falling into this trap. This 24 hour nature is an
attribute you want to transform into an edge in your favor. As a trader, you can put on or take off positions
literally any time of the day or night. That opens the game up to you if you don't have otherwise available time
to trade.
There is a number of major currencies involved, each of which is continuously interacting with all the
others. Chances are, at any given time, there is movement in at least one of those exchange rates simply
based on the offer-demand imbalance, or the number of global news events providing impetus to action.
Superior Liquidity
With such a tremendous daily trading volume, the Forex market can absorb trading sizes that dwarf
the capacity of any other market. This means a lot of trading liquidity and flexibility specially at London time,
New York and Tokyo (in this descending order).
There are always participants willing to buy or sell currencies in the Forex markets. Its liquidity,
particularly in major currencies, helps ensure price stability and market efficiency. Traders can almost always
open or close a position at a fair market price.
While it is true that currency markets have superior liquidity, it is also a fact that there are periods
when liquidity dries up. This can happen during very volatile times or periods of market uncertainty. A volatile
movement in price does not necessary mean a lot of volume, it can be just the opposite: fewer traders in the
market means a thiner liquidity, which can lead to a big imbalance between buyers and sellers, resulting in a
quick price movement in form of a spike or gap.
Because of the lower trade volume during the Asian session or even more during holiday seasons,
investors in the Forex market are also vulnerable to liquidity risk, which results in a wider dealing spread or
larger price movements in response to any relatively large transaction happening during these times.
Forex
High Leverage
The subject on leverage will thoroughly explained in chapter 3 and you will be taught how to take
advantage of it. Leverage trading means, in short, that you are permitted to trade up to 100 times your margin
deposit. This is primarily attributed to the higher levels of liquidity explained before.
A leverage of 1:100 means: in order to buy and benefit from one lot of 10,000 US Dollars you only have to
commit your 100 Dollars, the rest of the amount is leveraged by the market maker/broker.
While certainly not for everyone, the substantial leverage available with most online retail brokers in
the Forex market is an essential attribute of this market. Rather than merely loading up on risk as many
people incorrectly assume, leverage is essential in the Forex market. This is because the average daily
percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on
any given day.
A 100:1 leverage is commonly available from online Forex dealers, and sometimes even higher. This is
a both way weapon: on one hand it lets traders profit from a lot size much larger than their investments. But
on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker - that's right - but
that's not all: a too small leverage can be equally dangerous as you will learn in chapter 3.
The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to
diligently implement a risk management in your trading plan. You have to devise and adhere to a system
where your controls kick in when emotion might otherwise take over.
Margin Trading
The Forex market is a 100% margin-based market. This concept is strongly associated with the
previous one of leverage. Online Forex brokers offer many opportunities to open smaller accounts than in
other markets. That sort of flexibility opens the door to essentially anyone who wants to explore financial
trading. This isn't to say that all brokers are that flexible. There are, however, a great many which offer so-
called mini-contracts and even smaller accounts traded with micro-lots.
In fact, spot Forex trading is essentially trading a 2-day delivery transaction. This trade involves a cash
exchange between two currencies rather than a contract. For that, your broker requires a capital deposit to
provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will ask for as
little as 0,5%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.
Note that margin trading does not mean margin loans. Your broker will not be lending you money
to trade currencies (at least not the way a stock broker does). As such, there is no margin interest
charged. In fact, since you are the one putting money on deposit with your broker, you may earn
interest in your margin funds. This is what is referred to as the interest rate carry (or rollover).
When opening a position, one is essentially borrowing a currency, exchanging it for another, and
depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the
Forex
borrowed currency and at the same time earning the overnight rate on the currency being held.
If you are holding your position longer than one day, your broker rolls you forward into a new position for the
next trading day. This is generally done transparently and automatically, but it also means that at the end of
each day you will either pay or receive the interest differential on your position.
Some brokers will not apply the day's interest differential value on positions closed out during the
trading day. In this case, if you open a position with a negative interest rate differential, but you close it during
the same day, the differential is not applied.
Lower Transaction Costs

The over-the-counter structure of the Forex market eliminates exchange and clearing fees, which in
turn lowers transaction costs. There are usually no commissions in Forex retail trading because the trader
deals directly with a market maker.
You may ask, if Forex brokers don't charge commissions, how do they make money?
The broker makes money from the spread, which is the difference between what he pays for a currency and
the higher price at which he sells it. In other words, the spread is the width between the bid and ask prices,
which can be quite small in the major currency pairs, ranging between 2 and 5 pips.
Because of the currency market round-the-clock liquidity and the competition among market
makers, you receive tight, competitive spreads both intra-day and night.
The question if it is more cost-efficient to trade Forex in terms of both commissions and
transaction fees depends not only on your broker's conditions but also on your trading style. Forex
is more efficient if you know how to balance the number of trades and the earnings ratios. The
usual lack of commissions is another factor that, despite being an advantage, has to be well
understood to make it work in your benefit.
Profit Potential in Both Rising and Falling Markets
Every open Forex position has two sides because currencies are quoted in terms of their value against
each other. This is because currencies are traded in "pairs" (for example, US Dollar vs. Yen or US Dollar vs.
Swiss franc), one side of every currency pair is constantly moving in relation to the other.
When a trader is short in one currency he/she is simultaneously long on the other. A short position is one in
which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a
rising as well as in a falling market.
In some of the equity markets it is much more difficult to establish a short position due to the zero uptick rule,
which prevents traders from shorting a stock unless the immediately preceding trade was equal to or lower
t h a n t h e p r i c e o f t h e s h o r t s a l e .
This ability to sell currencies without any limitations can be seen as another distinct advantage of the Forex
market. You have equal potential to profit in both a rising or falling market, as there is no structural bias to the
market.
Forex
CHAPTER 2: The participants and their roles
1. Global Trade And The Currency Market - The Big Picture Matters
Before going into the interbank world and then examine the dealing processes, let's have a second
look at some key underlying economic principles of the modern history of global trade and capital flows,
partly covered in the previous chapter, and see why these developments still matter today.
As you learned in chapter A01, representatives from 44 different nations who converged at the
Bretton Woods conference in 1944 were determined to cobble together a system that would prevent
additional depressions and to ensure a fair and orderly market for cross-border trading conditions. Most
countries agreed that international economic instability was one of the principal causes of WWII, and that a
new system was needed to facilitate the reconstruction process.
At that time the US was not prepared to pay with their surplus the debt of the countries ruined by
war. And these, in turn, did not want to depend forever on the US economy. As a result, an agreement was
reached halfway: the conference produced a new exchange rate system which was partly a gold exchange
system and also a reserve currency system, with the US Dollar as a de facto global reserve currency.
While in the early 70s many economists supported the idea that the gold-US Dollar peg was not the
best regime for a growing international economy, a completely free floating exchange rate system was
neither seen as favorable as it could end up in competing devaluations, the destruction of cross-border trade
and ultimately lead to a global depression. The Smithsonian Agreement was an attempt to reestablish a fixed
rate system but without the backing of gold.
The value of the Dollar could fluctuate in a range of 2.25%, unlike the previous range of 1% during
the Bretton Woods. However, this agreement also failed in the end. Under heavy speculative attacks, the
price of gold shot to 215 US Dollars per ounce, the US trade deficit continued to rise and the Dollar,
therefore, could be devalued more than the 2.25% limit band set in the agreement. Because of this, the
currency markets were forced to close in February 1972.
Currency markets reopened in March 1973, when the Smithsonian agreement was already history.
The value of the US Dollar would be determined by market forces, and not be confined to a trading band or
be tied to any other asset. This allowed the Dollar and other currencies to adjust themselves to the global
economic reality and paved the way for an inflationary period never seen before in modern times.
Forex
The political understanding that underpinned Bretton Woods is of importance here, as the United
States made itself the core of the new system, agreeing to become the trading partner of first and last resort.
This has obviously tremendous implications on monetary matters. Although this has apparently no direct
implications on your daily trading, it is a key aspect to understand the market flows and many of the monetary
decisions taken by nations through their monetary authorities.
While nothing that has been discussed in the previous chapter is wrong, it is only part of the story. For
you as a trader and investor, there is a political dimension of the current system that matters, as it can
condition your career at some point. If you learn to identify the underlying forces that move the capital flows,
you will be able to develop trading strategies that fit the big picture.
Without an explicit mechanism like a gold exchange, the similarities between the original Bretton
Woods system and its more recent counterpart are interesting and instructive. Not only the system still relies
on the willingness of the participants to actively support it, but also today's system is characterized by the
economic and political relationship the US has with rapidly emerging economies.
For a time, the original Bretton Woods system seemed to favor all nations involved. Considering the
desperation and destitution of European countries and Japan, ruined by the war, they were willing to accept
nearly whatever was on offer in the hope of their rebuilding process. They were totally dependent upon US
willingness to remain engaged. On the other side, in view of the unprecedented and unparalleled US
economic strength, economic aid packets were the obvious way to go.
These emerging countries rebuilt their economies on the backs of their growing export markets. The United
States would allow Europe nearly tariff-free access to its markets. The sale of European goods in the US
would then help Europe develop economically and, in exchange, the United States would receive deference
on political and military matters: remember, NATO was born.
Forex
In the US growing affluence increased the demand for an ever-growing array of products from
overseas markets. Predictably US imports grew and so did the US trade deficit. A trade deficit increases
when the value of imports exceeds that of exports, the opposite of a trade surplus. In textbook economic
theory, market forces of supply and demand act as a natural correction for trade deficits and surpluses. One
would expect the value of a currency to appreciate as demand for goods denominated in that currency
increases.
Source: http://www.calculatedriskblog.com/
What happened however with the Bretton Woods arrangements was that the exchange rate
system mandated the foreign central banks to intervene in order to keep their currencies from exceeding
the Bretton Woods target levels.
They did this through foreign exchange market purchases of Dollars and sales of other currencies like
British Sterlings, German Marks and Japanese Yen.
This procedure resulted in lower export prices from these countries than what market forces would
predict, making them still more attractive for US consumers, thus perpetuating a mutual dependency on the
system.
Whereas in the original Bretton Woods the greatest limiter was the availability of gold,
now it has become and remains to be the whim of the US governments monetary authorities.
Forex
Once the monetary system discussed in the Bretton Woods conference was configured according to
the US plan, the chance of having a means of payment to cover the needs of international transactions and to
establish reserves to address potential deficits, that is, to have the necessary international liquidity, was given
by the gold reserves and US Dollars of those countries with some power over the International Monetary
Fund.
As many economies grew, more Dollars were demanded to be used in international trade. The
fundamental dilemma was: on the one hand, the US had to print more Dollars and run a balance-of-payments
deficit in order to satisfy that growing liquidity demand; on the other hand, a continued deficit led the US
Dollar to a loss of credibility as a sound reserve currency.
After the WWII, the United States was the only country able to provide all the material needs for the
reconstruction. European countries did not have enough Dollars and, since their reserves were low, they had
to become debtors of the United States, which meant that their balance of payments would have a surplus.
There was no other solution than to "beg" the Unites States to run a balance-of-payments deficit, which by
the way was also in the interest of the US.
The perpetuation of US deficits year after year would inevitably entail substantial risks for the
gold convertibility which was the backbone of the system. But the only way to provide
international liquidity, given the limited flexibility in the extraction of new gold, was deficits in the
north-American balance-of-payments or, put in another way, that other countries would
deliberately run a surplus in their balance-of-payments by accumulating Dollars.
To this contradiction between the need for Dollars (hence need for US deficits), and the confidence in
the Dollar's convertibility to gold (based on US metal reserves), we must add another aspect of the system.
This aspect discriminates different countries in relation to the US creating an asymmetry in their economical
decision taking processes: if a country had a deficit in its balance-of-payments and expected the situation to
continue, that country was under the obligation to proceed with an internal deflationary policy. Ultimately,
because the lack of sufficient reserves, the country had to take contractionary measures to devalue its
currency. But the US, being the creator of the system's underlying currency, was not forced to take that kind
of action.
A revival of Bretton Woods?

Much of the arrangements the Bretton Woods system brought into existence continue to be relevant
in today's global market. Some observers call it the "Bretton Woods II" making reference to the system of
currency relations in which currencies, particularly the Chinese renminbi (Yuan), remained pegged to the US
Dollar. The argument is that a system of pegged currencies is both stable and desirable although this notion
causes considerable controversy and opens the question: how long a system of heavily managed exchange
rates as seen in many emerging market economies will last?
Forex
The answer depends on the expectations of the US creditors, mainly the Asian economies. The
similarities between the original system and Bretton Woods II are evident: the US deficit, the US loose
monetary policies, the fixed pegs to the US, and the massive ongoing reserve accumulation by Asian central
banks. These exchange rate policies can lead to an inflation rise in those emerging economies forcing them to
abandon the pegs and/or letting currencies appreciate at a faster rate as a necessary step to control inflation.
Over the very long term, economies move in cycles and what were yesterday's emerging economies,
like Japan or Germany, become today's stable, mature markets while other countries step into the role of the
emerging countries and join the globalization party, such as the case of China, India, or Brazil. Suddenly it was
1944 all over again: what made economic sense for the emerging markets of yesterday continues to make
sense for those of today and likely for those of tomorrow.
Just like their predecessors, many of these countries, particularly China and other Asian economies,
believe today that keeping undervalued currencies is a key to grow and sustain their exports to the developed
markets of the US and Europe and thus to increase domestic wealth. This shows why fixed-rate systems
never died out completely. These countries' central banks see a weak currency as a critical element of the
country's export-oriented economic policy. But on the other side the inflationary pressures derived from this
monetary policy are creating serious problems to their economies.
The US trade deficit grew to unprecedented highs throughout the so-called Bretton
Woods II, supported by strong US consumer demand and the rapid industrialization of China and
other emerging economies. As of today, the US Dollar is still the most extended reserve currency
and the form in which many countries hold US debt instruments.
Clearly, any dramatic moves on the part of the countries that have accumulated large holdings of US
Dollar reserves to change the status quo arrangement would have the potential to create turbulence in
international capital markets. For instance, the political relationship between the US and China is also a
significant part of this equation and of the big picture itself. This has always been a sensitive political topic and
of much importance when considering the current monetary system.
Asian economies seem to be willing to perpetuate this status quo because the US consumer has supported
the growth of their economy during the last decades. But at this point you are surely raising questions like:
What happens if they don't want that debt anymore? Or, what if one or another member of this arrangement
concludes that its self-interest lies in abandoning the system? These are certainly questions that belong to a
broad analysis and for which you should try to find objective answers.
2. The Main Players In The Forex Market

When the US Dollar went off the gold standard and began to float against other currencies, the Chicago
Mercantile Exchange began to create currency futures to provide a place where banks and corporations
could hedge the indirect risks associated with dealing in foreign currencies.
Forex
More recently, currency gyrations have centered on a massive move away from currency futures to
more direct trading in the Forex spot markets where professional currency traders, alongside with
forwarding contracts, derivatives of all kinds, deploy their various trading and hedging strategies.
The idea of currency speculation has been actively marketed, and this is having a profound effect on
the foreign exchange planning not only of nations - through their central banks - but also of commercial and
investment banks, companies and individuals. These are the main categories of participants - a geographically
disperse Forex clientele - and as a consequence so is the market as a whole. In practice, the foreign exchange
market is made up of a network of players clustered in various hubs around the globe.
The key difference among these market participants is their level of capitalization and sophistication,
where the elements of sophistication mainly include: money management techniques, technological level,
research abilities and level of discipline.
Source: http://www.fxstreet.com/education/forex-basics/the-six-forces-of-forex/2006-06-29.html
Let's start dissecting the bigger players: the banks. Though their scale is huge compared to the
average retail Forex trader, their concerns are not dissimilar to those of the retail speculators. Whether a
price maker or price taker, both seek to make a profit out of being involved in the Forex market.
Forex
Commercial And Investment Banks

There are hundreds of banks participating in the Forex network. Whether big or small scale, banks
participate in the currency markets not only to offset their own foreign exchange risks and that of their
clients, but also to increase wealth of their stock holders. Each bank, although differently organized, has a
dealing desk responsible for order execution, market making and risk management. The role of the foreign
exchange dealing desk can also be to make profits trading currency directly through hedging, arbitrage or a
different array of strategies.
Accounting for the majority of the transacted volume, there are around 25 major banks such as
Deutsche bank, UBS, and others such as Royal bank of Scotland, HSBC, Barclays, Merrill Lynch, JP Morgan
Chase, and still others such as ABN Amro, Morgan Stanley, and so on, which are actively trading in the Forex
market.
Among these major banks, huge amounts of funds are being traded in an instant. While it is standard to
trade in 5 to10 million Dollar parcels, quite often 100 to 500 million Dollar parcels get quoted. Deals are
transacted by telephone with brokers or via an electronic dealing terminal connection to their counter party.
Source: http://www.Euromoney.com forex survey
Many times banks also position themselves in the currency markets guided by a particularly view of
the market prices. What probably distinguishes them from the non-banking participants is their unique access
to the buying and selling interests of their clients. This "insider" information can provide them with insight to
the likely buying and selling pressures on the exchange rates at any given time. But while this is an advantage,
it is only of relative value: no single bank is bigger than the market - not even the major global brand name
banks can claim to be able to dominate the market. In fact, like all other players, banks are vulnerable to
market moves and they are also subject to market volatility.
Forex
Similar to your margin account with a broker, the banks have established debtor-creditor
agreements between themselves, which make the buying and selling of currencies possible. To
offset the risks of holding currency positions taken as a result of customer transactions, the banks
enter into reciprocal agreements to quote each other throughout the day on preset amounts.
Direct dealing agreements can include that a certain maximum spread will be upheld, except
under extreme conditions, for example. It can further include that the rate would be supplied in a
reasonable amount of time.
For instance, when a costumer wants to sell 100 million Euro, the procedure is as follows: the bank's
sales desk receives the costumer's call and inquires the dealing desk at which exchange rate they are able to
sell to the costumer. The costumer can now accept ordeny the offeredrate. As a market maker, the
bank has to handle the order in the interbank market and assume the risk for that position as long as there is
no counterpart for that order.
Let's assume that the customer accepts the bank's buy price then the Dollars are immediately
credited to the customer. The bank has now an open short position over 100 million Euro and has to find
either another costumer order to match with this order, or a counter party in the interbank market. To do
such transactions, most banks are nourished by electronic currency networks in order to offer the most
reliable price for each transaction.
The interbank market can therefore be understood in terms of a network, consisting of banks and
financial institutions which, connected through their dealing desks, negotiate exchange rates. These rates are
not just indicative, they are the actual dealing prices. To understand the uniformity of prices, we have to
imagine prices being instantaneously collected from crossed prices of hundreds of institutions across an
aggregated network.
Besides of the available technology, the competition between banks also contributes to the tight spreads
and fair pricing.
Forex
Central Banks
The majority of developed market economies have a central bank as their main monetary authority.
The role of central banks tends to be diverse and can differ from country to country, but their duty as banks
for their particular government is not trading to make profits but rather facilitating government monetary
policies (the supply and the availability of money) and to help smoothen out the fluctuation of the value of
their currency (interest rates).
Central banks hold foreign currency deposits called "reserves" also known as "official reserves" or
"international reserves". This form of assets held by central banks is used in foreign-relation policies and
indicates a whole lot about a countries' ability to repair foreign debts and also indicates a nation's credit rating.
While in the past reserves were mostly held in gold, today they are mainly held in Dollars. It is
common for central banks nowadays to possess many currencies at once. No matter what currencies the
banks own, the Dollar is still the most significant reserve currency. The different reserve currencies that
central banks hold as assets can be the US Dollar, Euro, Japanese Yen, Swiss franc, etc. They can use these
reserves as means to stabilize their own currency. In a practical sense this means monitoring and checking the
integrity of the quoted prices dealt in the market and eventually use these reserves to test market prices by
actually dealing in the interbank market. They can do this when they think prices are out of alignment with
broad fundamental economic values.
The intervention can take the form of direct buying to push prices higher or selling to push prices
down. Another tactic that is adopted by monetary authorities is stepping into the market and signaling that an
intervention is a possibility, by commenting in the media about its preferred level for the currency. This
strategy is also known as jawboning and can be interpreted as a precursor to official action.
Most central bankers would much rather let market forces move the exchange rates, in this case by
convincing market participants to reverse the trend in a certain currency.
As you see, holding reserves is a security and strategic measure. By spending large reserves of foreign
currency, central banks are able to keep the value of their currency high. If they instead sell their own
currency they are able to influence its price towards lower levels. The consequence of central banks having
purchased other currencies in an attempt to keep their own currency low results, however, in larger
reserves. The amount central banks hold in reserves keeps on changing depending on monetary policies, on
supply and demand forces, and other factors.
Businesses & Corporations

Not all participants have the power to set prices as market makers. Some just buy and sell according
to the prevailing exchange rate. They make up a substantial allotment of the volume being traded in the
market.
Forex
This is the case of companies and businesses of any size from a small importer/exporter to a multi-
billion Dollar cash flow enterprise. They are compelled by the nature of their business - to receive or make
payments for goods or services they may have rendered - to engage in commercial or capital transactions that
require them to either purchase or sell foreign currency.
Fund Managers, Hedge Funds and Sovereign Wealth Funds

With Forex trading surging in recent decades, and as more individuals earn their living trading, the
popularity of riskier investment vehicles like hedge funds has increased. These participants are basically
international and domestic money managers. They can deal hundreds of millions, as their pools of investment
funds tend to be very large.
Because of their investment charters and obligations towards their investors, the bottom line of the
most aggressive hedge funds is to achieve absolute returns besides of managing the total risk of the pooled
capital. Foreign exchange advantage factors like liquidity, leverage and relatively low cost create a unique
investment environment for these participants.
Generally speaking, fund managers invest on behalf of a range of clients including pension funds,
individual investors, governments and even central banks. Also government-run investment pools known as
sovereign wealth funds have grown rapidly in recent years.
This segment of the foreign exchange market has come to exert a greater influence on currency trends
and values as time moves forward.
Internet Based Trading Platforms

One of the great challenges to the institutional Forex and how exchange related businesses are being
handled has been the emergence of the Internet-based dealing platforms. This medium contributed to form a
diverse global market where prices and information are freely exchanged.
As evidenced by the emergence of electronic brokering platforms, the task of customer/order
matching is being systematized as these platforms act as direct access points to pools of liquidity. The human
element of the brokering process - all the people involved between the moment an order is put to the trading
system until the moment it is dealt and matched by a counter party - is being reduced by the so called
"straight-through-processing" technology.
Similar to the way we see prices on a Forex broker's platform, a lot of interbank dealing is now being
brokered electronically using two primary platforms: the price information vendor Reuters introduced a web
based dealing system for banks in 1992, followed by Icap's EBS - which is short for "electronic brokering
system"- introduced in 1993; replacing the voice broker.
Both the EBS and Reuters Dealing systems offer trading in the major currency pairs, but certain
currency pairs are more liquid and are traded more frequently over either EBS or Reuters Dealing. For
instance, EUR/USD is usually traded through EBS while GBP/USD is traded through Reuters Dealing.
Forex
Cross currency pairs are generally not quoted on either platform, but are calculated based on the
rates of the major currency pairs and then offset through the legs. Some exceptions are EUR/JPY and
EUR/CHF which are traded through EBS and EUR/GBP which is traded through Reuters.
As mentioned above, the interbank market is based on specific credit relationships between banks. In
order to trade with other banks at the rates being offered, a bank may use bi-lateral , or multi-lateral order
matching systems, which have no intermediary bank or dealer. These unofficial foreign exchange platforms,
like the ones mentioned earlier, have emerged in the absence of a worldwide centralized exchange.
In the early 90s, when these interbank platforms were introduced, it is also when the FX market opened for
the private trader, breaking down the high minimum amount required for an interbank transaction.
Along with banks, non-banking Forex participants of all types are being given a choice of available
trading and processing systems for all scales of transactions. Around the same time as interbank platforms
were introduced, web based dealing systems that corporations could use in lieu of calling banks on the phone
also began to appear. These trading platforms include today FXall, FXconnect, Atriax, Hotspotfx, LavaFX
and others. All of them are easily available on the Internet for your further research.
These hubs provide a crucial step for the non-banking participants (broker-dealers, corporations and
fund managers, for example) allowing them to by-pass bank market makers in the first instance, and reducing
costs substantially offering direct access to the market.
These professional platforms were followed by the first web based dealing platforms for the retail sector.
Today there are hundreds of online Forex brokers whose business is focused on providing services to the
small trader or investor, a phenomenon that mirrors what is already happening at the interbank level.
Source: BIS.org Triennial Survey 2007

Forex
Online Retail Broker-Dealers

In the previous sections you have come to understand how the Forex market works. Now let's see
how its inner workings can affect your trading by learning more about retail Forex brokers.
If you want to exchange one currency for another and make some profit, just like most individuals,
you are unable to access the pricing available on the interbank market. You can't just barge into Citigroup or
Deutsche Bank and start throwing Euros and Yen around, unless you are a multinational or hedge fund with
millions of Dollars. To participate in the Forex, you need a retail broker, where you can trade with much
inferior amounts.
Brokers are typically very large companies with huge trading turn over, which provide the
infrastructure to individual investors to trade in the interbank market. Most of them are market makers for
the retail trader, and in order to provide competitive two way prices, they have to adapt to the technological
changes afoot in the industry, as we have seen above.
What does it mean to directly trade with a market maker? Every market maker has a dealing desk,
which is the traditional method that most banks and financial institutions use.
The market maker interacts with other market maker banks to manage their position exposure and
risk. Every market maker offers a slightly different price in a particular currency pair based on their order
book and pricing feeds.
As trader, you should be able to produce gains independently if you are using a market maker or a
more direct access through an ECN. But nevertheless, it's always essential to know what happens on the
other side of your trades. To gain that insight, you first need to understand the intermediary function of a
broker-dealer.
The interbank market is where Forex broker-dealers offset their positions, but not exactly the way
banks do. Forex brokers don't have access to trading in the interbank through trading platforms like EBS or
Reuters Dealing, but they can use their data feed to support their pricing engines. Enhanced price integrity is a
major factor traders consider when dealing in off-exchange products, since most prices originate in
decentralized interbank networks.
In order to quote prices to their costumers and offset their positions in the interbank market, brokers
require a certain level of capitalization, business agreements and direct electronic contact with one or several
market maker banks.
You know from chapter 1 that the Forex spot market works over-the-counter, which means there
are no guarantors or exchanges involved. Banks wanting to participate as primary market makers require
credit relationships with other banks, based on their capitalization and creditworthiness.
The more credit relationships they can have, the better pricing they will get. The same is true for retail
Forex brokers: depending on the size of the retail broker in terms of capital available, the more favorable
pricing and effectiveness it can provide to its clients. Usually this is so because brokers are able to aggregate
several price feeds and always quote the tighter average spread to its retail customers.
This is a simplified example how a broker quotes a price for the GBP/USD:
Forex
The broker selects the higher ask price (Bank D) and the lower bid price (Bank C) and combines it to the best
possible market rate at:
In reality, the broker adds its margin to the best market quote in order to make a profit. The price finally quoted
to the costumers would be something like:
When you open a so called "margin account" with a broker-dealer, you are entering into a similar
credit agreement, where you became a creditor towards your broker and he, in turn, a borrower from
you.
What do you think happens the moment you open a position? Does the broker route the amount to
the interbank market? Yes, he may do it. But he can also decide to match it with another order for the same
amount from another of his clients, since passing the order through the interbank means paying a commission
or spread.
By doing so, the broker acts as a market maker. Through complex matching systems, the broker is
able to compensate orders of all sizes from all its costumers between each other. But since the order flow is
not a zero equation - there may be more buyers than sellers at a certain time - the broker has to offset this
imbalance in his order book taking a position in the interbank market. Obviously, many of these brokering
functions have been significantly computerized, cutting out the need for human intervention.
The broker may also assume the risk, taking the other side of this imbalance, but it's less probable that
he assumes the entire risk. On one hand, the statistics showing the majority of retail Forex traders loosing
their accounts, may contribute to the appeal of such a business practice. But on the other hand, the spread is
where the real secure and low risk business lies.
From the previous chapter, you already know that Forex trading bears its transactions costs. Alone
these costs prevent the order flow from being an absolute zero equation because entering and exiting the
market is not free: every time you trade you pay at least the spread. From this perspective, the order flow is a
negative sum game.
Forex
In Forex there is another type of brokers labeled "non-dealing-desk" brokers. They act as a conduit
between customers and market makers/dealers. The broker routes the customer's order to another party to
be executed by the dealing desk of the market maker. For this service brokers generally charge fees and/or
are compensated by the market maker for the transactions that they route to their dealing desk.
As you see, either trading with a market maker or with a NDD broker, your order always ends up in a dealing
desk.
In comparison with the mentioned brokerage models, the ECN brokers provide collected exchange
rates from several interbank and non-interbank participants buying and selling through the platform. With
such a platform, all participants are in fact market makers. Besides trading directly, anonymously and without
human intervention, each participant sends a price to the ECN as well as a particular amount of volume, and
then the ECN distributes that price to the other participants.
The ECN is not responsible for execution, only the transmission of the order to the dealing desk from
which the price was taken. In this system, spreads are determined by the difference between the best bid and
the best offer at a particular point in time on the ECN. In this model, the ECN is compensated by fees charged
to the customer and eventually a rebate from the dealing desk based on the amount of volume or order flow
that it is given from the ECN.
It is important to point out that an ECN usually shows the volume available for trading each bid and
offer, so the trader knows what maximum trade can be placed. ECN volume is only a reflection of what is
available on any one ECN, not in the overall market. The market maker's responsibility is to provide liquidity
under all conditions to its customers.
For success as a trader, it's not determining whether you trade through a market maker, non-dealing-
desk or ECN broker. However, retail brokerage demands a due diligence, particularly in terms of regulation,
execution speed, tools, costs and services. So you would do well to investigate thoroughly any broker you're
planning to use.
3. Doing Brokers Due Diligence

Due to enormous competition between Forex broker-dealers, they offer different features and
advantages. However, choosing a broker is not an easy task for any new or experienced trader.
There are some key aspects like regulation and capitalization which speak for the reliability and competence
of the organization and which can be measured following certain objective criteria.
But the real challenge in choosing a broker comes when you have to determine what attributes you
are looking for. Along with the outstanding features, you might find a potential weakness, depending on what
you need for your trading style.
For example, if your trading performance depends on guaranteed liquidity but you can account for
variable spreads, this may be what you should look for. On the other hand, you might prefer a fixed pip spread
if you know you are getting instant executions despite of market conditions, if this is essential for your trading.
Forex
With so many Forex broker-dealers out there, it may be a little confusing finding the one that fits your
needs and financial capabilities. To that end, as part of the Learning Center, here are the main criteria to look
for when investigating a broker:
Support
One of the first thing you should check in a broker is the support service. Forex is a 24-hour market,
so ideally, the broker you choose should offer support at anytime.
Which medium is used to contact the help desk: email, chat, or can you speak by phone to a live
person? Do the representatives seem knowledgeable? How they respond to your questions can be key in
gouging how they will respond to your needs in a real situation.
While trading you can run into technical problems. Therefore try to anticipate those critical situations
and simulate those questions and requests to your broker. You can do this while experimenting on a demo
account.
The website should already explain things clearly, but be sure to check the quality and efficiency of
their support before opening an account.
Capitalization
As you already know, the better capitalized the market makers are, the more credit relationships they
can establish with their liquidity providers and the more competitive pricing they can get for themselves as
well as for their clients.
The OTC nature of the market makes extremely difficult for a broker to get competitive pricing
without a margin deposited in a lending institution or bank. As a result, it is extremely important for individual
investors to do extensive due diligence on the Forex broker with which they choose to trade.
If a broker-dealer states that they are safe to work with because they trade in the interbank market,
you know what this means. To date, the interbank market is an unregulated and loose conglomerate usually
traded by central banks, investment banks and extremely large corporations.
As a member of a regulatory authority, a broker must comply with a minimum capitalization level.
This fact has a direct relationship with its ability to stay solvent and is also indicative of the size of
the company.
The minimum capitalization required in the US is currently (Jan 09) at $ 10,000,000, and the trend is
to gradually raise up to $ 20,000,000 over the next months. If the broker does not publish this information, it's
a warning sign that could mean a lack of solvency.
As an auxiliary data you could try to find out if the broker has big clients such as hedge funds or
corporations. Some of these data are public as regulated and audited hedge funds have to mention their
Forex
access gates to the market. A broker chosen by a large hedge fund is normally indicative that the
broker is reliable, complies with all regulations and has enough liquidity.
Regulation
Not all countries supervise the Forex brokers and dealers the same way, nor do they have the same
regulatory environment and requirements when it comes to financial registration. Therefore, it is important
for any trader to choose a broker that is based in a country where their activities are monitored by a
regulatory agency. It is also important to know if the broker or dealer is regulated in an on- or offshore
country, as the latter can be more liberal with registration requirements.
You want to be aware of the broker or dealer's regulatory status and have a clear understanding of the
regulatory body that governs Forex activity where the selected broker or dealer does its business.
The authority of a regulated Forex broker is located in the country where the broker is registered in.
For example, Forex brokers in the US should be registered as a futures commission merchant with the
Commodity Futures Trading Commission. The CFTC ensures that the broker meets strict financial
standards. The broker should also be a member of the National Futures Association (NFA).
US companies supervised by these three organizations are more likely to be legitimate than those that are
not. In addition, there is a lot of information that can be found with these organizations that can help you
further your broker research. Usually, you can spot the registered status of the broker and other financial
information on its own website. A regulated Forex broker will not hide the fact of being regulated and who is
the authority in charge.
Dealing with a Forex broker-dealer that is registered with the CFTC and the NFA is one way to
minimize your vulnerability, but this isn't to say that you should dismiss firms that are based outside the United
States or subject to non-US regulators. The Financial Services Authority (FSA) in the United Kingdom and the
Investment Dealers Association of Canada are also strident in their defense of the rights of retail Forex
traders.
The point is to do your due diligence on a regular basis verifying that the firm is registered and in good
standing with the regulator in place. Also, make certain that you understand your rights and the enforcement
mechanisms available to you should you have difficulty with the broker-dealer.
At the National Futures Association (NFA) website, you can check if the broker is a registered FCM (Futures
Commission Merchant ), and also check for any record of fines or deceptive trade practices by the
broker/dealer in question.
Main Regulatory Organizations

Australia :
Australian Securities and Investment Commission
Forex
Canada :
British Columbia Securities Commission
Ontario Securities Commission
Investment Dealers Association of Canada
Cyprus :
Cyprus Stock Exchange Commission
Denmark :
Danish FSA
European Monetary Union :
Markets in Financial Instruments Directive
France :
Banque de France
Germany :
Bundeszentrale für Finanzdienstleistungsaufsicht
Hong Kong SAR :
Securities and Futures Commission
Japan :
Financial Services Agency
Japan Investor Protection Fund
The Financial Futures Association of Japan
Japan Securities Dealers Association
Kanto Local Finance Bureau
Singapore :
Licensed clearing member of the Singapore Exchange
Monetary Authority of Singapore
Spain :
Comisión Nacional del Mercado de Valores
Sweden :
Swedish Financial Supervisory Authority (Finansinspektionen)
Switzerland :
Groupement Suisse des Conseils en Gestion Indépendants
Polyreg
Association Romande des intermediares financiers
Swiss Federal Department of Finance
Organisme d'autorégulation fondé par le GSCGI
Commission fédérale des banques
Swiss Financial Market Supervisory Authority (FINMA)
Forex
United Kingdom :
Financial Services Authority
United States :
Financial Industry Regulatory Authority, Inc.
New York Stock Exchange
Securities and Exchanges Commission
Commodities and Futures Trading Commission
National Futures Association
Costs: Fee And Commission Structures

The Forex market, unlike other exchange driven markets, has a unique feature that many market
makers use to entice traders to trade: they promise no exchange fees or regulatory fees, no data fees and,
best of all, no commissions. In the previous chapter we have already mentioned that this advantage has to be
well understood, because when it comes to evaluating costs, it much depends on your trading numbers such
as frequency, ratios and other performance related statistics.
Basically, there are three commission structures used by Forex brokers: a fixed spread, a variable
spread and/or a commission charge based on a percentage of the spread. Just a quick reminder: spread,
usually calculated in pips, is the difference between buying and selling price.
So, which is the best choice?
On the one hand, you may think that the fixed spread is the right choice, because then you know
exactly what to expect. On the other hand, you might think you are getting a good deal paying a variable but
smaller spread.
First of all, consider that the best deal you can get is choosing a reputable broker who is well capitalized, has
strong relationships with the large foreign exchange banks and can provide the liquidity you need to trade
well. Second, you need to calculate the impact of all possible fee structures on your trading model to know
which one is more favorable to you.
Some Forex brokers don't charge a commission, so the spread is how they make money. The lower
the number of pips required per trade by the broker is, the greater the hypothetical profit that the trader
makes is. Comparing pip spreads of half dozen brokers will reveal different transaction costs.
In the case of a broker who offers a variable spread, you can expect a spread that will, at times, be as
low as 1 pip or as high as 7 pips on the most major pairs, depending on the level of market volatility. While
market makers provide two-way pricing to customers throughout the day, these prices can be quoted on a
fixed basis, meaning that they do not move throughout the day. But they can also use a dynamic spread
system, which means the prices change as the liquidity in certain pairs change.
Forex
While market makers provide two-way pricing to customers throughout the day, these prices can
be quoted on a fixed basis, meaning that they do not move throughout the day. But they can also
use a dynamic spread system, which means the prices change as the liquidity in certain pairs
change.
A lack of liquidity in the markets or very volatile market conditions can force the broker to apply a
slippage on the pricing. Slippage, also called "requote", occurs when your trade is executed away from the
price you were offered, when you end up paying more pips than the average spread. This is perhaps a cost
that you don't want to bear if you are trading very short term or if you trade the news.
Asking your broker how they handle news times and if they have any devise to protect you from
experimenting slippage is probably a good idea. You can decide to trade with fixed spreads, even if they are a
little higher in average but receive, in exchange, an instant fill of your trades at the desired prices.
Some brokers even offer you the choice of either a fixed spread or a variable one.
Other brokers, like ECN brokers, may also charge a small commission, usually in the order of two-
tenths of one pip. Whether you should pay a small commission depends on what else the broker is offering.
For example, the broker may pass your orders on to a large market makers conglomerate. You might choose
a broker with such an arrangement, if you look for very tight spreads only larger investors can otherwise get.
Nevertheless, the spread with an ECN broker is not fixed, and it always depends on the current market
depth. Besides, their platforms may not be so user friendly as retail platforms and they usually lack
charting tools. In addition, payment and withdrawal options are less efficient when compared to retail
brokers and accounts openings require higher minimum amounts. But if a broker offers, in exchange of a
commission, access to a superior proprietary software platform or some other benefit like a real time
news feed, in this case, it may be worth paying the small commission for this additional service.
So what is the bottom line effect of each type of spread or commission on your trading? Given that it
much depends on your trading profile, this is a difficult question to answer. There are some factors to
take into account when weighing what is most advantageous for your trading and that depends on your
trading capabilities and preferences.
An important and not very discussed aspect when considering trading costs are the rollover charges.
These are determined by the difference between the interest rate of the country of the base currency and the
interest rate of the other country. The greater the interest rate differential between the two currencies, the
greater the rollover charge. We will cover these concepts in more detail in the next chapter, but as a matter of
broker choice, take into account that not all brokers charge the same rollovers for the same pairs.
However, before you jump in and choose a broker based on the type of commission structure, consider the
total broker's package, otherwise you may be sacrificing other benefits. For example, some brokers may
offer excellent spreads but their platforms may not have that personal preference feature you need for your
trading to work.
Forex
Platforms
The existing Forex brokers offer different trading platforms for their clients along with extensive
tools and research. These trading platforms almost always feature real-time quotes for several currency
pairs, integrated charting and news, technical analysis tools, a deal log and even integration for automated
trading systems.
Real-time exchange rate quotes are not the only feature a retail platform should provide. Closely examine the
screen layout in search for an account summary with your current account balance with realized and
unrealized profit and loss; the margin available and locked in open positions; leverage; rollover charges in
open positions; open position sizes, and performance reports.
One of the reasons why some of the trading software applications look similar is because some
dealers, instead of creating their own software, prefer to offer other platforms for client use which were
created by the same manufacturer and "white labeled". Regardless who is the creator, the important factors
are always the same: intuitive design, ease of use, speed and reliability. Most trading platforms are either Web
based (in Java), or download trading platforms you can install on your computer.
Which one is better? This is something you should decide by yourself. Web based software is hosted
on your broker's server. You won't have to install any software on your own computer and you'll be able to log
in from any computer that has an Internet connection.
It should be pointed out that, in most cases, you will only find trading platform applications to run on
Microsoft Windows. Using another operating system, you won't be able to install the application and a web
based or Java-based trading platform is the solution for those cases.
Java-based software tends to be less vulnerable to attacks from viruses and hackers during
transmissions than client-based software. But on the other hand, the client-based programs run faster.
A client-based software will only allow you to trade on your own computer, unless you install the
program on every computer you use.
Whether download or web-based, make sure that the trading set-up has every trading tool you need,
including charts, news, available currencies etc., and that you have a high speed Internet connection. The
Forex market is a fast moving market and you will need up-to-the second information to make informed
trading decisions.
Speed is thus a little bit more subjective and can depend on the speed of your computer
and Internet connection. But the actual technology is probably less important than knowing how
fast someone will pick up the phone should you have a problem with the software and need to get
out of a trade.
You are free to use a charting platform and an execution (trading) platform from two different
providers, and even add a news feed from a third source.
Forex
Nearly all brokers align their hours of operation to coincide with the hours of operation of the global
Forex market: 5:00 pm EST Sunday through 4:00 pm EST Friday.
Perhaps other valuable differentiators for you are trailing stops to lock in profits, real-time news, wireless
trading, or pattern recognition charting.
One of the backbones of any trading platform is the ordering system, whether you can hedge
positions, increment or reduce the size of a position, trail stop loss orders, close and invert a position, etc.
Get a feel for the options that are available by trying out different demo accounts. Order types will be
covered in next chapter in more detail, but for now remember that the decision about what order types are
best depend on each trading style.
Brokers usually also provide technical and fundamental commentaries, economic calendars and
other research as part of their service. Ask them if the information is freely available or only to costumers, and
compare it with other sources.
Before committing to any broker and opening a real account, be sure to request free trial accounts,
so-called "demo" accounts, to test the platforms and its many features. The demo account should be free at
least for 30 days, so you can paper trade the platform and test if it fits your needs.
Account Types
Many brokers offer two or more types of accounts. These can be very small mini-accounts and even
smaller micro-accounts, or standard accounts, depending on the lots traded. A lot consisting of 100,000 units
is called a standard lot; a lot consisting of 10,000 units is called a mini lot; and a lot consisting of 1,000 units is
called a micro lot. Some brokers even offer fractional unit sizes which allow you to establish your own
position size.
The micro and mini-accounts allow you to trade with a very low minimum of capital, while the
standard accounts often require a higher minimum initial capital, varying from broker to broker.
As you see, the account types differ from each other according to the minimum trading size
requirements. Choosing a specific account type should be relative to your amount of capital. This concept
may seem a bit nebulous if you are just starting out, but rest assured it will be made clear once you start
learning about leverage and money management.
Margin Requirements and Leverage
Another thing that you should check in a Forex broker-dealer is leverage options and the margin call
policy.
Foreign exchange traders, specially aspiring traders with limited capital, tend to like higher leverages
and sometimes choose a broker based only on this feature. However, traders should remember that
although higher leverage can lead to higher profits, it also increases the level of risk. Understand that leverage
is like a loan. It might be just as beneficial as detrimental to your capital. Low margin requirements (meaning
high leverage) are great when you make profits, but not so great when you loose.
Forex
Some brokers offer fixed leverage levels, while others adjust their leverage based on the currency
that is being traded and may also have special policies for carrying a trade over the weekend. For example,
less leverage (and therefore less risk) may be preferable if you trade highly volatile (exotic) currency pairs.
Traders should also take into account their broker's margin call policy. Some companies follow the
FIFO (first in first out) method to close trades when margin requirements are not met by current equity, others
follow the LIFO (last in first out) procedure, and some simply close all the trades. Depending on one's
preferences, this is an issue that should be clearly identified before opening an account.
Maximum leverage levels are more of a concern for aggressive traders who like to use the highest
possible leverage, whereas a moderate or conservative trader would be happy with the average leverage
levels.
Most brokers pay interest on a trader's margin account. The interest rates normally fluctuate with the
prevailing central bank's interest rates of the countries whose currencies you are trading. This is an interest
which the margin capital in your account accrues. Ask your broker if there is a minimum margin requirement
that allows you to accrue the interest.
Finding the right broker-dealers is a critical part of the process to become a trader and requires some
real work on your part. Many of the mentioned criteria will be very relative until you define your trading
profile and methodology. Therefore, don't forget to come back to this chapter as you progress in modeling
your trader's profile.
Just to summarize: investigate, interrogate and cross-examine a series of Forex brokers before you
jump in! Test broker's platform with demo accounts and make sure to scrutinize their terms and conditions to
be fully aware of all the nuances that a specific broker may impose on your trading.
Here is a checklist you can use in your due diligence:

How well capitalized is the broker/dealer?
Is the company registered, and where? Get the firm's registration ID number and look it up at the above
mentioned websites.
How long has it been in business?
Who manages the firm and how much experience does this person have?
Does the firm have partner companies?
Which and how many banks does the firm have relationships with?
What is their capitalization level?
What kind of platform does it offer- web based or client software?
What is their margin policy?
What rollover policy does the broker have?
Does the firm guarantee stop loss execution?
Does it have the order types that you need for your trading?
Can you speak to the dealing desk if they have one?
Do they guarantee liquidity also for big order sizes?
Forex
Charter 3: Understand the Mechanics
1. Currencies and Currency Pairs
The Exchange Rate

The concept of buying and selling capital can be confusing because you're not buying anything in
exchange for money, like you do in the stock market, for example. Instead you are simultaneously buying one
currency and selling another.
In the stock market, traders buy and sell shares; in the futures market, traders buy and sell contracts;
in the Forex market, traders buy and sell "lots". When you buy a currency lot, you are speculating on the value
of one currency compared to another, on the exchange rate itself.
Currencies are traded in pairs. The pair is written in a particular format, best demonstrated by way of two
examples. The Euro and the US Dollar:
EUR/USD
or the British Pound and the Japanese Yen:
GBP/JPY
Every purchase of one currency implies a reciprocal sale of the other currency, and vice versa. This
means that buying equals selling - curious isn't it? But the fact is that you are buying and selling the
exchange rate, not a single currency.
Imagine if currencies would be traded single and you would want to buy 100 US Dollars. Do you think
it would be easy to find someone offering more than 100 Dollars for the same amount? Probably not. The
value of a currency does not change in itself, what changes is its value in relation to other currencies. This is a
characteristic of a free floating exchange rate system, as you learned in the previous chapter.
If you hear another trader saying "I'm buying the Euro", he/she is expecting that the value of the Euro
will rise against the US Dollar and speculates by buying the EUR/USD exchange rate. The trader's ability to
anticipate how the exchange rate will move will determine if the trade will represent a win or a loss.
The first member of every pair is known as the "base" currency, and the second member is called the
"quote" or "counter" currency. The International Organization for Standardization (ISO) decides which
currency is the base and which one is the quote within each pair.
The exchange rate shows how much the base currency is worth as measured against the counter
currency. For example, if the USD/CHF rate equals 1.1440, then one US Dollar is worth 1.1440 Swiss francs.
Remember, the value of the base currency is always quoted in the counter currency member within the pair
(hence the name "quote currency"). A simple rule to understand the exchange rates would be to think of the
base currency as one unit of that currency being worth the value of the exchange rate expressed in the quote
currency.
Forex
Following the example above, one US Dollar is worth 1.1440 Swiss Francs.
Therefore, any unrealized profit or loss is always expressed in the quote currency. For example,
when selling 1 US Dollar, we are simultaneously buying 1.1440 Swiss francs. Likewise, when buying 1 US
Dollar, we are simultaneously selling 1.1440 Swiss francs.
We can also express this equivalence by inverting the USD/CHF exchange rate to derive the
CHF/USD rate, that is:
CHF/USD = (1/1.1440) = 0.0874
This means that the quote of one Swiss franc is 0.0874 US Dollars. Note that CHF has now become
the base currency and its value is accrued in USD.
In spot Forex, not all pairs have the US Dollar as the base currency. Primary exceptions to this rule are the
British Pound, the Euro and the AusHtralian and New Zealand Dollar.
GBP/USD, EUR/USD, AUD/USD, NZD/USD
When looking at a chart you can see if a currency pair, or in other words, the exchange rate between
two currencies, is rising or falling.
In the above example the chart illustrates the strength of the base currency, the Euro, relative to the
quote currency, the US Dollar. Remember, the quote currency is the one in which the exchange rate is
quoted.
Forex
The next chart shows the same base currency but this time relative to the Australian Dollar. Both charts
comprise the same period and as you can see, the value of the Euro has shown a different behavior towards
the USD than towards the AUD.
In a free floating system, there are two main factors that can affect exchange rates every day: international
trade (import/export of commodities, manufactured goods and services) and capital flows (following certain
interest rates, equity performance, government debt instruments like bonds).
It is by buying and selling a currency, therefore exchanging it with other currencies, that it becomes
stronger or weaker, independently from the fact that this transaction was speculative or not.
Currencies reflect the performance and policies of entire economies, sovereign governments and
industry. It is the comparison of different currencies and their economies that drives exchange
rates up and down.
Basically there are two main methods to estimate where a currency is heading: the fundamentals and
price action.
The first refer to the economic and political factors that influence the value of currencies, such as the
release of economical data and news. The second are graphical representations of the exchange rates like
you see above. Graphs show offer and demand levels and price patterns which can be recognized visually.
And as a numerical sequence, prices can be also technically analyzed using mathematical formulas.
Forex
Currency Pairs
The following is a list of the most frequently traded currencies, their trading symbols, their nicknames
and major characteristics:
USD (US Dollar)
The US Dollar is by far the most transacted currency in the world. This is due to several factors as you have
already learned in the last chapter. First, it's the world's primary reserve currency, which makes this currency
highly susceptible to changes in interest rates. Second, the USD is a universal measure to evaluate any other
currency as well as many commodities such as oil (hence the term "petrodollar") and gold.
Today's other major currencies like the Euro, the British Pound, the Australian Dollar and New
Zealand Dollar are moving against the American currency, and so do the Japanese Yen, the Swiss franc and
Canadian Dollar.
70% of the U.S economy depends on domestic consumption, making its currency very susceptible to data on
employment and consumption. Any contraction in the labor market has a negative effect on this currency.
All US Dollar denominated bank deposits held at foreign banks or foreign branches of American banks
are known as "Eurodollars". Some economists maintain that the overseas demand for Dollars allows the
United States to maintain persistent trade deficits without causing the value of the currency to depreciate and
the flow of trade to readjust. Other economists believe that at some stage in the future these pressures will
precipitate a run against the US Dollar with serious global financial consequences.
Nickname: Buck or Greenback
EUR (Euro)
The European Monetary Union is the world's second largest economical power. The Euro is the currency
shared by all the constituting countries which also share a single monetary policy dictated by the
European Central Bank (ECB).
Forex
This currency is both a trade driven and a capital flow driven economy. Before the establishment of
the Euro, central banks didn't accumulate large amounts of every single European national currency, but with
the introduction of the Euro it is now reasonable to diversify the foreign reserves with the single currency.
This increasing acceptance as a reserve currency makes the Euro very susceptible to changes in interest
rates.
The effect of the Euro competing with the Dollar for the role of reserve currency is misleading. It
gives observers the impression that a rise in the value of the Euro versus the US Dollar is the effect of
increased global strength of the Euro, while it may be the effect of an intrinsic weakening of the Dollar itself.
Nickname: Fiber or Single Currency
JPY (Japanese Yen)
The Japanese Yen, despite belonging to the third most important single economy, has a much smaller
international presence than the Dollar or the Euro. The Yen is characterized by being a relatively liquid
currency 24 hours.
Since much of the Eastern economy moves according to Japan, the Yen is quite sensitive to factors
related to Asian stock exchanges. Because of the interest rate differential between this currency and other
major currencies that preponderated for several years, it is also sensitive to any change affecting the so-called
"Carry Trade". Investors were then shifting capital away from Japan in order to earn higher yields. However, in
times of financial crisis when risk tolerance increases, the Yen is not used to fund carry trades and is punished
accordingly. When volatility surges to dangerous levels, investors try to mitigate risk and are expected to park
their money in the least risky capital markets. That means those in the US and Japan.
The concept of carry trade will be disclosed later in this chapter, but a short definition would be: a
strategy which involves buying or lending a currency with a high interest rate and selling or borrowing a
currency with a low interest rate.
Forex
Japan is one of the world's largest exporters, which has resulted in a consistent trade surplus. A surplus occurs
when a country's exports exceed its imports, therefore an inherent demand for Japanese Yen derives from
that surplus situation. Japan is also a large importer and consumer of raw materials such as oil. Despite the
Bank of Japan avoided raising interest rates to prevent capital flows from increasing for a prolonged period,
the Yen had a tendency to appreciate. This happened because of trade flows. Remember, a positive balance of
trade indicates that capital is entering the economy at a more rapid rate than it is leaving, hence the value of
the nation's currency should rise.
GBP (Pound Sterling)

This was the reference currency until the beginning of World War II, as most transactions took place
in London. This is still the largest and most developed financial market in the world and as a result banking and
finance have become strong contributors to the national economical growth. The United Kingdom is known
to have one of the most effective central banks in the world, the Bank of England (BOE).
The Sterling is one of the four most liquid currencies in the Forex arena and one of the reasons is the
mentioned highly developed capital market.
While 60% of the volume of foreign exchange are made via London, the Sterling is not the most
traded currency. But the good reputation of the monetary policy of Great Britain and a high interest rate for a
long time contributed to the popularity of this currency in the financial world.
Nickname: Cable or Sterling
CHF (Swiss franc)

Forex
Several factors such as a lengthy history of political neutrality and a financial system known for
protecting the confidentiality of its investors, have created a save heaven reputation for Switzerland and its
currency. Being the worlds largest destination of offshore capital.
The Swiss franc moves primarily on external events rather then domestic economic conditions, and is
therefore sensitive to capital flows as risk-averse investors pile into Franc-denominated assets, during global
risk aversion times. Also much of the debt from Eastern European economies is denominated in Swiss Francs.
Nickname: Swissy
CAD (Canadian Dollar)
Canada is commonly known as a resource based economy being a large producer and supplier of oil. The
leading export market for Canada is by far the United States making its currency particularly sensitive to
US consumption data and economical health.
Being a highly commodity dependent economy, the CAD is very correlated to oil - meaning that when oil
trends higher, USD/CAD tends to trend lower and vice versa.
Nickname: Loonie
AUD (Australian Dollar)
Australia is a big exporter to China and its economy and currency reflect any change in the situation in
that country. The prevailing view is that the Australian Dollar offers diversification benefits in a portfolio
containing the major world currencies because of its greater exposure to Asian economies. This
correlation with the Shanghai stock exchange is to be added to the correlation it has with gold. The pair
AUD/USD often rises and falls along with the price of gold. In the financial world, gold is viewed as a safe
haven against inflation and it is one of the most traded commodities. Together with the New Zealand
Dollar, the AUD is called a commodity currency. Australia's dependency on commodity (mineral and
farm) exports has seen the Australian Dollar rally during global expansion periods and fall when mineral
prices slumped, as commodities now account for most of its total exports.
Forex
The interest rates set by the Reserve Bank of Australia (RBA) have been the highest among
industrialized countries and the relatively high liquidity of the AUD has made it an attractive tool for carry
traders looking for a currency with the highest yields. These factors made the AUD very popular among
currency traders. It's the 6th most traded currency in the world accounting for an estimated 6.8% of
worldwide FX transactions in 2007, far in excess of the economy's importance (2% of global economic
activity).
The AUD is under a free floating regime since 1983. Before that it was pegged to a group of
currencies called the trade weighted index (TWI).
Nickname: Aussie
NZD (New Zealand Dollar)

This currency behaves similar to the AUD because New Zealand's economy is also trade oriented
with much of its exports made up of commodities. The NZD also moves in tandem with commodity prices.
As per estimates from the last BIS triennal survey, in 2007 the NZD accounted for a daily transaction
share volume of 1,9% of total Forex transactions, after the Norwegian krone, the Hong Kong Dollar and the
Swedish krone.
Along with the Australian Dollar, the NZD has been for many years a traditional vehicle for carry
traders, which has made this currency also very sensitive to changes in interest rates. In 2007 the NZD was
mainly used to conduct carry trades against the Japanese Yen accounting for a higher volume than the
Australian Dollar against the Yen.
Nickname: Kiwi
Although there are many currencies worldwide, the vast majority of all daily transactions involve the
exchange of the so called "major" currency pairs:
US Dollar / Japanese Yen (USD / JPY)
Euro / US Dollar (EUR / USD)
Pound Sterling / US Dollar (GBP / USD)
US Dollar / Swiss Franc (USD / CHF)
US Dollar / Canadian Dollar (USD / CAD)
Australian Dollar / US Dollar (AUD / USD)
Forex
The pair is always expressed with the convention: Base currency / Quote currency set by the
Society for Worldwide Interbank Financial Telecommunication cooperative (SWIFT).
According to the last triennial survey from 2007 made by the Bank of International Settlements, this is
the daily turnover in the Forex market per major pairs.
EUR/USD 27%
USD/JPY 13%
GBP/USD 12%
AUD/USD 6%
USD/CHF 5%
USD/CAD 4%
USD/Other 19%
For traders, the best trading opportunities are those related to the major currencies, because those are
traded more frequently and are therefore more liquid.
Other currency pairs are referred to as "minors" or "exotic" pairs. These are some of the lesser-
traded pairs that contain the USD and a currency from a smaller and/or emerging economy:
USD/SEK (US Dollar / Swedish krone)

USD/NOK (US Dollar / Norwegian krone)
USD/DKK (US Dollar / Danish krone)
USD/HKD (US Dollar / Hong Kong Dollar)
USD/ZAR (US Dollar / South African rand)
USD/THB (US Dollar / Thai baht)

USD/SGD (US Dollar / Singapore Dollar)
USD/MXN (US Dollar / Mexican peso)
Other pairs where the US Dollar is not a member currency are called "crosses". Basically, a cross is any
currency pair in which the US Dollar is neither the base nor the counter currency. For example, GBPJPY,
EURJPY, EURCAD, and AUDNZD are all considered currency crosses.
When you think about buying or selling a cross currency pair, don't forget that the US Dollar, despite
not being a member within the pair, is still influencing the price behavior of the cross. Buying EUR/JPY is
equivalent to buying the EUR/USD currency pair and simultaneously buying the USD/JPY. Knowing from the
previous chapter how interbank platforms work, you also understand why cross currency pairs frequently
carry a higher transaction cost. To build a cross, interbank dealers have to combine two orders on different
platforms.
The figure below shows the process of creating a cross currency pair.
Forex
By knowing how currencies are related and transacted you will be given a basic understanding on how
to analyze trading opportunities on majors as well as on crosses. The principles guiding you to profit from a
trade with a cross should be technically the same as with the majors: basically you want to analyze which is the
strong and which is the weak currency within the pair.
By the same token, as crosses are created at the interbank level, you can create your crosses if they
are not available with your preferred broker-dealer's platform. We call that creating "synthetic" pairs.
Let's assume a trader believes, based on a previous analysis, that there is an opportunity to profit from
a weak Swedish krone (SEK) and a strong Norwegian krone (NOK), but the broker-dealer which the trader
is using doesn't enable to sell the pair SEK/NOK. In this case all it takes is the trader to buy USD/SEK and to sell
USD/NOK with equal position sizes. The position size depends on the pip value of the pair you are
trading, as you will see later in this chapter.
Too many new concepts? Don't worry, we will get there in a moment.
The figure below illustrates the process of synthetic pairing.
Forex
Note:
 If Canada is one of the world's largest producers of oil and is such a big part of the US economy, rising
oil prices tend to have a negative effect on the USD and a positive effect on the CAD. Here you have two nice
correlations.
But if you are willing to find a pair which is really sensitive to oil prices, then pick the CAD/JPY. Canada and
Japan are at the extreme ends of production and consumption of oil. While Canada benefits from higher oil
prices, Japan's economy can suffer because it imports nearly all of the oil it consumes. This is another
interesting correlation to follow.
 What is a commodity currency? A commodity currency is a currency whose country's exports are
largely comprised of raw materials (precious metals, oil, agriculture, etc.).
Among the most actively traded and therefore liquid currencies are the NZD, the AUD and the CAD.
"Commodity Dollars" or "Comdolls" is another term to describe these currencies.
 The EUR/USD is the most liquid currency pair and all pairs containing the EUR are very liquid. This
currency is the result of the replacement of all largest European national currencies, such as the
Deutsche Mark, French franc, Italian lira, Dutch guilder, the Belgian franc, etc. The conversion of
these legacy currencies into one, coupled with the ongoing process of deregulation of cross-border
transactions, enhanced market efficiency and helped the single currency challenge the supremacy of
the US Dollar in international transactions. As described in the BIS quarterly review of December
2007, "...the Euro area market currently accounts for 16% of total international interbank activity, up
from 10% in 1998. Much of this has been fueled by greater use of the Euro, whose share in the
interbank market hovered around 70% until 1998, but then increased steadily and has stabilized at
86% since 2003."
 If you trade several pairs simultaneously, don't get overweight in one currency, unless the risk has
been diversified. For instance, buying the EUR/USD and being short in the USD/CHF is like having
twice the exposure to the same factors, as these pairs are highly correlated.
You'd better monitor several pairs and trading just one, for instance, by following the EUR/GBP when
trading the GBP/USD. Although the GBP/USD is a more liquid currency than EUR/GBP, EUR/GBP is
typically a good indicator for GBP strength.
 The US Dollar Index measures the performance of the US Dollar against a basket of world currencies.
This basket consists of the following currencies and their percentage weighting.
Euro 57.6%
JapaneseYen 13.6%
Great Britain Pound 11.9%
CanadianDollar 9.1%
Swedishkrona 4.2%
Swiss franc 3.6%
Forex
...Since the Euro makes up a major portion of this basket, it is rather obvious that
it should have a strong correlation with the US Dollar Index.
2. Measuring The Trade
The Spread
As with other financial instruments, there is a price an investor can sell at which is called "bid"
price, and a price the investor can buy at which is called "ask" price.
From the broker-dealers' perspective, the bid is the price at which the broker-dealer is prepared to buy,
therefore to "bid" a specific currency pair from you as a trader. At this price, you can sell the base
currency to the broker-dealer.
For example, in the quote EUR/USD 1.2872/73, the bid price is 1.2872. This means you sell one
Euro for 1.2872 US Dollars.
In turn, the ask is the price at which the broker-dealer is prepared to sell (is "asking" for) you a
specific currency pair. At this price, you can buy the base currency. It is shown at the right side of the
quotation. Sometimes it's also called the "offer" price.
Using the same EUR/USD quote, the ask price is 1.2873. This means you can buy one EUR for 1.2873 US
Dollars. The ask price is also called the offer price.
The difference between both prices is known as the "bid-offer spread" or "the spread", and it's expressed
with a similar quote convention than the pair:
Bid / Ask
In our example, the spread value would be of 1 point, the difference between 1,2873 (the price
the broker-dealer is ready to sell) and 1,2872 (the price the broker-dealer is ready to buy at).
So to summarize:
Example: EUR/USD 1.2872/73
Ask Price: 1.2873
Bid Price: 1.2872
Spread: 1 point
Forex
Another example illustrates that the bid price of the AUDUSD pair is 0,6520 USD and the offer
price is 0.6528 USD:
AUD/USD = 0.6520/28
The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-
turn trade.
The formula for calculating the transaction cost is:

Transaction cost = Ask Price Bid Price
The spread in this case is made of 8 points, also called "pips".
The spread is usually lower in the majors, since a high turnover assures ample liquidity to meet the
trading needs. That is why interbank and retail dealers charge less for the majors through the spread. For less
traded pairs or cross currency pairs the spread will be bigger, since at an interbank level these trades may
involve the use of synthetic pairing and dealers have to assume more risk in completing those transactions.
To sum up 1000 pips trading the EUR/USD, a medium or long-term trader can make one or two
trades that move that amount of pips. Assuming an average spread of 2 pips, the trader has to make 2 or 4 pips
to overcome the spread.
To reach the same amount of pips with a scalping method, let's say with 50 round turns, and assuming
the same average spread on the EUR/USD, the cost will be of 100 pips (50 trades x 2 pip-spread). In terms of
costs that's a lot of pips less effective than a long-term trader!
The PIP
In equities or futures, the smallest unit of measurement is called "tick" or "point". In Forex this unit is
called a "pip" (for Percentage In Point). As shown in the most trading platforms a pip is the 4th decimal place
after the comma or, which is the same, the ten-thousandths place in the quoted exchange rate (0.0001).
A well known exception is any currency pair that contains the Japanese Yen where a pip is the 2nd
decimal after the comma (0.01). The same happens with the Thai baht.
The reason to establish a common incremental unit in Forex is due to the fact that differently to
equities which are all quoted in the same currency, in Forex each currency can be quoted in any other
currency. That makes sense, doesn't it?
If the exchange rate of a currency pair moves from 1.3000 to 1.3010, we say that the price
moved up 10 pips. The pip incremental is what shows if a position is winning or losing. So you make
money when the pips move in your favor in a trade.
Forex
An increment of a single pip has a certain value and in the case of direct-quote pairs (pairs quoted in
US Dollars) that value is 10 US Dollar per standard lot, and 1 US Dollar per mini lot. Other currency pairs, like
reverse quote pairs (with the USD being the base currency), and cross rates (pairs without the USD) will have
different pip values.
Despite the fact that there are online calculators and that most of the platforms do the math for you,
knowing how the pip value is calculated is something that really matters in your risk management. In order to
calculate how much one pip is worth, the following information is needed: the trading size and the actual
exchange rate of the pair to be traded. Moreover you may need the exchange rate of your account's currency
to the Dollar. Let's see some practical examples.
The formula to calculate the value of a pip can be divided into three categories:
1. Currency Pairs With Direct Quote (EURUSD, GBPUSD)

For currency pairs with direct quote the pip value is constant and doesn't depend on the current
exchange rate of the pair being traded.
pip value = (lot size) X (pip size, with the corresponding decimal location / exchange rate)
where the exchange rate is always the ask price.
Here is an example with the EUR/USD with the quote being 1.2599/1.2600.
€
100,000 X (0.0001 / 1.2600) = €
7.93 = 1 pip
However, to get the value of the trade in Dollars, then multiply €
12.6 by the current EURUSD quote:
€
7.93 X 1.2600 = $ 9.99 ($ 10.00 rounded up)
This phenomenon is observed when the Dollar is the counterpart or quote member within the pair:
the pip value is always the same.
In the above example, a EUR/USD standard lot represents 100,000 Euro which can buy 126,000 US
Dollars at the exchange rate of 1.2600. Therefore, the EUR/USD currency pair could be expressed as
100,000 EUR / 126,000 USD.
If you buy the EUR/USD and it moved up by one pip to 1.2601 you have earned $10. You can see the
difference by substracting the pair as 100,000 EUR/126,010 USD. The amount of USD has grown on the
right side of that equation by $10- the value of the pip.
2. Reverse Quote Pairs (USDJPY, USDCHF)

For those pairs having the USD as the base currency the pip value measured in Dollars is calculated
with the same formula as with direct quote pairs:
pip value = (lot size) X (pip size / exchange rate)
Forex
However, in reverse quote pairs the pip value in US Dollars changes depending on the current quote.
For example, exchanging a standard lot with the pair USD/JPY at the rate 107.00, the pip would be worth:
$ 100,000 X (0.01/107.00) = $ 9.346 = 1 pip
In these cases you don't need to exchange the pip value to US Dollars in order to get the face value of the
trade, because the lot size is always in the base currency and so is the pip value.
3. Cross-Rates (GBPCHF, EURJPY etc.):
The pip value measured in Dollars in cross currency pairs is a little trickier.
For example: with the EUR/NZD rate representing 1 / 2.5040, or expressed in a standard lot, 100,000 EUR /
250,400 NZD at the current exchange rate, if the pair moves up one pip to 2.5041 then the position would
have incremented 5,03 US Dollars per pip.
Too abstract? Alright, this is the formula:
pip value = (lot size) X (pip size) X (base exchange rate / exchange rate)
where the base exchange rate is the current quote of the base currency against US Dollar, and the
exchange rate is, like in the previous formulas, the current quote of the traded pair. Therefore:
€
100,000 X 0.0001 X (1.2600 / 2.5040) = $ 5.03 = 1 pip
For cross-rates the pip value is changing depending on the current exchange of the traded pair AND the base
currency exchange rate to the US Dollar. Got it? Great!
The formula seems complicated because we are converting it to US Dollars. But if your account is in
EUR and the traded pair is the EUR/NZD, then you don't need to input the base exchange rate in the
calculation. Supposing you buy a standard lot of EUR/NZD, the value of the pip is:
€
100,000 X (0.0001/2.5040)= €
3.99 = 1 pip
For professional investors trading large amounts paying 1 or 1.2 Dollar per pip can make a huge
difference.
Now you know how to combine the two concepts of pip value and lots. Important to recall once
more:
When you buy or sell a pair to enter a position, the face value is calculated in the base currency, the
first within the pair.
When you close and exit a position, the win or loss depends on the amount of pips and on the pip
value. The profit or loss is initially expressed in the pip value of the quote currency (the second). To determine
the total profit or loss, you must multiply the pip difference between the open price and closing price by the
number of units of the currency traded.
Forex
The pip value can be calculated in different ways depending if the traded pair is a direct rate (pairs
quoted in US Dollars), a reverse rate (with the USD being the base currency) or a cross rate pair (pairs
without the USD).
As each currency has its own value related to another, it's important to take these factors into account
to refine the money management at an optimal level.
Supposing you were planning similar trades on the GBP/USD, the GBP/JPY and the EUR/GBP with
the rates as of January 2009. The pip values expressed in US Dollars would be approximately:
GBP/USD (1.4700): $ 10p
GBP/JPY (134.00): $ 7.47
EUR/GBP (0.8700): $ 8.7
where the value in brackets is the ask price of the exchange rates.
In this scenario you should account for the fact that a 100 pip stop loss or 200 pip target on the
GBP/USD is 33% more valuable than in the GBP/JPY and 15% more valuable than in the EURGBP because of
the difference in pip values.
But if we take the rates in, let's say, July 2007, the differences where even greater:
GBP/USD (2.0150): $ 10
GBP/JPY (247.00): $ 4.04
EUR/GBP (0.6700): $ 6.7
At that time, there was a huge difference of more than 50% in the pip value (expressed in US Dollars)
between the GBP/USD and the GBPJPY. The image below shows line charts for the three pairs and the
corresponding pip values.
Forex
Depending on your account size, trading one pair or the other will bring a different volatility to your
account balance. In fact, the pip value serves to fine-tune the value of a trade by measuring what your possible
profits and risks are worth.
Another aspect to consider is that when the pip value is lower in one pair than in another, the risks that
market participants are willing to take in this pair are probably wider in terms of pips. This may increase the
daily range of certain pairs or the placement of stop orders as we will see further in this chapter.
The bottom line is that you could be taking riskier positions unintentionally if you don't know how
to consider the pip values.
In terms of risk management the lesson is not over yet! In order to calculate the real value of the trade
you are now able to consider trading costs such as spreads or commissions and the pip value. But there is
another intrinsic aspect of the Forex market to be considered: interest rates.
The Interest Rate (Rollover)
Forex traders make money either buying low then selling high, or selling high then buying low. Profits
and losses are determined by the opening and closing prices and by the pip value as you have studied in the
previous section. However, profits and losses will also be affected by the different interest rates of the
currency pair - by when the trades actually settle and how long the position is held.
Rest assured that the importance of this topic can eventually represent an advantage to your trading. Let's
proceed by recalling the concept of exchanging two currencies from the beginning of the chapter.
Every currency trade involves selling one currency and buying another. This exchange is the same
as borrowing one currency to buy another. Since every pair consists of two currencies
representing two economies with two different interest rates, most often it derives in an interest
rate differential in the pair. This differential will, in turn, result in a net earning or payment of
interest.
The interest that is earned or paid is usually the target interest rate set by the central bank of the country
that issues the currency. More precisely, the interest rates used are the short term overnight LIBOR and
LIBID rates, because most of the spot trades are short term. These are typically set by the British
Banker's Association and are changed on a daily basis.
Countries don't change interest rates often, therefore the interest earned or paid can change on a daily basis
but will typically not change very much. So a trader does not have to worry about timing the market too
closely on this subject.
The interest is debited (paid) on the currency that is borrowed, and credited (earned) on the one that
is bought, so that each pair has an interest payment and an interest charge associated with holding the
position. This means that if a trader is buying a currency with a higher interest rate than the one he/she is
borrowing, the net differential will be positive and the trader will earn funds as a result.
Depending which member currency within the pair has the higher interest rate, on some pairs a
payment may be made if you are buying it, and a charge may be made if you are selling it. But on other pairs, an
interest payment may be made by selling it and a charge occurs when buying.
Forex
Most Forex broker-dealers automatically roll over the positions from one day to the other until the
trader closes the position - a process called, naturally enough, a "rollover". Practically all trading platforms
adjust the rollover to your account automatically, so you do not have to calculate it. This premium can also
be called using the terms "swap", "tomorrow-next," or "cost of carry".
The rollover is necessary to avoid the actual delivery of the currency. As spot Forex is predominantly
speculative, most of the time traders never request the actual delivery of the currencies they trade. Besides,
delivering the currency is almost impossible with the leverage effect, because there is usually not enough
capital to cover the transaction.
Since the amount of the rollover is determined by the interest rate differential, the greatest
interest can be earned by buying the currency that pays the highest interest and selling the
currency that charges the lowest interest.
In the spot Forex market, delivery of the underlying is immediate as opposed to forward delivery. But
as briefly explained in chapter 1, the delivery is technically a two-day maturity transaction. This means that
the exchange of funds, also called "settlement", takes place two business days after the entry date- the date
when the trade has been accepted by the broker-dealer. The date of settlement is known as the value date or
delivery date, as it refers to the date on which the foreign exchange deal is due to mature. Rollovers, in effect,
continually delay the actual settlement of the trade until the trader closes his/her position.
Settlement for most pairs, often depicted as T+2, takes 2 days because most of the transactions are
made between continents with different time zones. The exception are North American currency pairs,
comprised of USD, CAD or MXN (Mexican peso), whose settle is 1 good business day (T+1).
As explained before, the net interest is either added or deducted from the trader's account at the end
of each trading day as long as the position is open.
Because currency trading is a 24-hour global market, there needs to be an agreement as to what
constitutes the end of the day. By convention, the broker-dealer's settlement time or "cut-off time" is 5 P.M.
Eastern Standard Time (EST) or 10 P.M. GMT in winter or 9 P.M. GMT in summer.
The reason this particular time is used is because according to the International date line, when it is 5
P.M. In New York, it's Monday morning in Australia and New Zealand hence it marks the beginning of a trading
day and week.
At the settlement time (5P.M. EST), a new good business day starts. So for any trade opened at or
after 5 P.M. EST on Monday, the trade day will be considered Tuesday. For a trade opened at latest 4:59 P.M.
EST the trade day is still the day of the opening of the trade.
With these conventions in mind we can now deduce that a trade in EUR/USD opened at 2 P.M. EST
Monday would settle on Wednesday at 5 P.M. because the trade day would be still Monday, and 2 full maturity
days later is Wednesday at 5 P.M. EST. because the trade day would be still Monday, and 2 full maturity days
later is Wednesday at 5 P.M. EST.
Forex
However, if the same currency pair were to be traded after 5 P.M., let's say at 8 P.M. on Monday, then
the trade day would be Tuesday and the settlement date would be Thursday at 5 P.M. EST.
Moreover, for a T+2 currency pair that was traded after 5 P.M. EST on Wednesday, the trade date is
Thursday. Now, if we add 2 good business days it would settle on Saturday. But because the market is
e s s e n t i a l l y c l o s e d o n S a t u r d a y a n d S u n d a y, t h e v a l u e i s e x t e n d e d t o M o n d a y.
Since interest is calculated for every day while position is held, including weekends and holidays, the amount
of interest credited or debited depends on the number of days between rollovers. If the rollover period is
extended because of holidays, then the additional holidays are counted as well. This can lead to several days
especially at the end/beginning of the year.
By the same logic, if you do not want to earn or pay interest on your positions, simply make sure they
are all closed before 5 P.M. EST, the established end of the business day.
There are basically two ways that broker-dealers use to pay or charge this premium. One is through
an actual payment or charge to your account balance, the other is by resetting and adjusting your position in a
more or less favorable price depending if the rollover is positive or negative.
This process of resetting your position means simultaneously closing and opening it, so that if you are
owed a premium your entry is reset to a lower entry price on a buy trade. Likewise, when selling and owing a
premium, your entry price will be reset to be slightly higher, that means a less favorable one than it was
originally.
On most trading platforms the premium is clearly visible on the control panel and also in the account
statements. As mentioned before, many trading platforms or broker-dealer's websites will also show the
amount of positive or negative rollover for each currency pair that can be traded, thereby informing the
trader beforehand of the interest rate differential.
Also note that many retail broker-dealers do adjust their rollover rates based not only on the LIBOR
short term rates, but also on your account leverage and account type. That is why you should check your
broker-dealer on rollover rates and crediting/debiting procedures.
Now we are going over the rollover a little more in depth so that you understand how it is calculated -
despite being an automated process in most cases.
As an example we will take the pair AUD/USD, which has been for a long time the one with the greatest
rollover differential.
Imagine that you are long one mini lot on the AUD/USD and the current interest rates as defined by
the overnight rate is 7.60% and 4.20% respectively. In order to net those two interest rates we calculate:
Rollover AUD/USD Buy = ((LIBID USD − LIBOR AUD) X Lot Size) / 100% / 365
where 365 is the number of days in a year.
The formula explained in several steps is:
Forex
First you calculate the difference between the overnight interest rates of the two currencies involved in the
pair:
(7.60 4.20) = 3.4
Sometimes here you have to subtract a small percentage which is the portion that charges the broker-
dealer for the service.
Second, the difference between the two interest rates has to be multiplied by the amount of the base
currency held in the trade:
((3.4) X 10,000 AUD) = 34,000 AUD
Divide that amount by 100 (%) and then by 360 days to arrive at a close approximation of the interest
premium payment in the base currency per day:
34,000 AUD / 100 / 360 = 94.44 AUD
If the base currency of the position you hold is different from the currency you hold your account in,
convert it to your currency multiplying the above result by the current rate between the base currency and
your account currency.
94.44 AUD X 0.8455 (AUD/USD) = $ 79.84
If you were short the AUD/USD you would reverse the first part of the equation and find the amount
you should be charged to be holding that position.
((- LIBOR USD + LIBID AUD) X Lot Size) / 100% / 365
An interesting aspect you can observe in the above calculation is that when borrowing and buying
currency lots, the net premium, either positive or negative, is calculated in accordance to the size of the
position.
Usually the trader doesn't have such amount of capital because the transaction is leveraged. But still
the broker-dealer pays or charges with a premium for that amount of capital. That is why the rollover is
dependent on the leverage. This is the next subject to understand the mechanics of trading.
3. Margin and Leverage
Lots and Position Sizes

In Forex the minimum amount of currency you have to buy is called one "lot". That means that units of
currencies are grouped and traded in lots. At a retail level, lots are divided into several categories: the so-
called "full-size" or "standard" lots, "mini" lots, "micro" lots and "flexible" or "fractional" lots.
A standard lot consists of 100,000 units of whatever the base currency in the currency pair is. A mini
lot consists of 10,000 units of the base currency and a micro lot 1,000 units of the base currency.
Forex
As you can see, a mini contract is one-tenth the size of a standard contract and the micro lot o n e -
tenth of the minilot. Flexible lots, in turn, allow the trader to choose the exact amount of units of the base
currency to buy or sell.
Differentiated by the lot sizes there are also several types of accounts that a trader can open with a
retail broker-dealer. While a standard account controls 100,000 units per lot traded, a mini account and a
micro account control one lot size lower respectively.
So for instance, when buying one micro lot on the GBP/USD, you would buy 1,000 British Pounds and sell an
equivalent amount of US Dollars.
Let's suppose the current exchange rate for GBPUSD is 2.4500 and you want to buy 10,000 US
Dollars worth of this pair. Here's the math:
For pairs with USD as the quote currency, take the Dollar amount you want to purchase and divide it by the
exchange rate:
(desired position size) / (current rate) = # of units
that is:
10,000 US Dollars / 2.4500 = 4081.63 units of GBPUSD
As you can see, this is approximately 4 mini lots of British Pounds. If your broker-dealer doesn't offer
fractional lot sizes you can always round up or down.
Buying a pair with USD as the base currency is much easier to calculate. Why? Because in these cases you just
buy the amount of units you want because you are purchasing US Dollars, the base currency.
And in the case of a cross pair transaction, when buying 10,000 US Dollar worth of GBPCHF, for
instance, we purchase 4081.63 units of GBPUSD at the above rate and sell 10,000 units of USDCHF.
Being able to choose among several lot sizes is a huge advantage retail Forex trading offers to the
small investor. It allows you to tailor and fine tune your money management to better meet your
trading style.
If you have a very small account size keep your risk profile low by choosing a dealer that offers micro or
fractional lot sizes. Even many seasoned traders avoid standard contracts to be more precise in their position
sizing.
The Concept of Leverage
A very extended and poor definition of leverage is that it's a tool that will help traders earn money fast
and easy. And indeed, one of the most important advantages of the Forex market is given by the effect of
leverage! Without leverage, it would be very difficult to accumulate capital by trading the market, especially
for small investors. But leverage can also be very harmful if not properly understood. This duality is what
makes this concept difficult to grasp and explains partly why there are so many misconceptions about it.
Forex
Financial leverage, meaning a purchase on a margin, is the only way for small investors to participate in
a market that was originally designed only for banks and financial institutions. Leverage is a necessary feature
in the Forex market not only because of the magnitude of capital required to participate in it, but also because
the major currencies fluctuate on average less than 2% per day.
Without leverage, the Forex would not attract capital from the retail sector. It is designed to allow a
greater market share to investors in accordance with their investment capacity.
Leverage is therefore a form of credit or loan, which allows us to trade with money from the broker-
dealer. Financial leverage is also defined as the use of foreign capital per unit of capital invested.
In fact, the mechanism of leverage is what enables the existence of broker-dealers. They also have
accounts in different banks which serve them as liquidity providers, thus acting as lenders of first resort for
the broker-dealer's margin transactions. This means that the bank allows the broker-dealer to trade with
larger amounts of capital and the broker-dealer, in turn, transfers this benefit to the user. The capital
deposited in the bank guarantees limited risk, as does your deposit with the broker-dealer.
Margin Trading
When conducting a Forex transaction, you are not actually buying all that currency and depositing it
into your account. Technically, you are speculating on the exchange rate and contracting with your broker-
dealer that they will pay you, or you will pay them, depending if the exchange rate moves in your favor or not.
A trader who purchases a USD/JPY standard lot does not have to put down the full value of the trade
(100,000 USD). But to gear up the trade size to institutional level, the buyer is required to put down a deposit
known as "margin". The minimum deposit capital varies from broker to broker and can range from $100 to
$100,000.
That is why margin trading can be seen as trading with borrowed capital it's basically a loan from the
broker-dealer to the trader, but based on the trader's deposited amount. Margin trading is what allows
leverage.
In the above example, the trader's initial deposit serves as a guarantee (a collateral) for the leveraged
amount of 100,000 USD. This mechanism insures the broker-dealer against potential losses. As you see, you
are not using the deposit as a payment or purchase of currency units. It is rather a good-faith deposit, made by
the trader to the dealer or broker.
When executing a new trade, a certain percentage of the deposit in the margin account will be frozen
as the initial margin requirement for the new trade. The quantity of required margin per trade depends on the
underlying currency pair, its current exchange rate and the number of lots traded. Remember, the lot size
always refers to the base currency. The frozen initial margin requirement may not be used in trading until the
trade is closed.
The more positions are opened simultaneously the more margin is required until it eventually
becomes a notable percentage of your account.
Forex
Many aspiring traders hope to make huge gains only with the help of leverage, but in reality they are draining
their accounts systematically. It's not a difficult thing to do: just open an account with $1,000 and start trading
by opening a position, let's say, in the USD/CAD with a size of 3 mini-lots ($3,000). In the case the position
loses 100 pips, the account will be left with $700.
Now you may feel tempted to recover the previous loss with a 50 pips gain trading with 6 mini lots.
But if the trade loses another 50 pips, you will have lost $300. With the remaining $400, you may think in
recovering the initial deposit trading 4 mini lots, and go for 150 pips, and so on... With each loss a recovery
becomes less and less feasible because of the increase of leverage.
Leverage is the main reason why so many novice traders (and not so novice) are swept from the
market. Combining their small accounts with ultra high leverages, they are an easy prey for the
less leveraged and professional traders.
The belief that leverage can offset losses with big gains leads many aspiring traders to increase
leverage when they experience a series of losses. Typically, the account will suffer a substantial loss. When
these losses drain the account to less than the minimum margin account level, the broker-dealer will close the
position and leave them with whatever is left in the account. This is how to "blow up" an account.
Margin Call- a Guaranteed Limited Risk

In the futures market, a losing position may go beyond the deposited margin, and the trader will be
liable for any resulting deficit in the account. In Forex this will not happen as the risk is minimized through the
mechanism of a "margin call".
Most online trading platforms have the capability of automatically generating a margin call when your
margin deposits have fallen below the required minimum level because an open position has moved against
you.
In other words, when the losses exceed the deposit margin, all open positions will be closed
immediately, regardless of the size of positions held within the account.
Leveraged Trading
Trading currencies on margin lets you increase your buying power. If you ask your broker-dealer what
their margin requirement is for a standard lot they will give you a relatively small amount, typically $1,000.
When you trade with $5,000 in margin and you control 5 standard lots worth of $500,000, that's a 100:1
leverage, because you only have to post one percent of the purchase price as collateral.
This means the trader has to have at least $5,000 ($5,000 + spread to be more precise) in the margin account
to trade 5 full size lots.
Forex
A common way to calculate the margin required per trade is the following: suppose you have 100:1
leverage from your broker-dealer. The maximum trade size is then calculated as amount in USD x 100.
Supposing you decide to buy one standard lot of GBP/USD. To figure out the amount of capital which has to
be set aside as margin for the value of the deal, we need to take the current rate for GBP/USD (let's say
2.0200) and do the following:
(2.0200 * 100,000)/100 = $2020.00
Should the account balance equal or drop below the margin requirement, the broker-dealer would
liquidate all open positions on a margin call. That means that using $2020 in margin and trading one standard
lot with $10,000 in the account, if the trade would go negative by $7981, a margin call would occur.
IF (margin account) (position value) < min. margin requirement
THEN
$10,000 $7,981 = $2,019 < $2,020 → margin call!

In reverse quote pairs, the currency denomination for the leverage is already in USD. In the case you
would decide to buy a standard lot of USD/JPY at a rate of 105.00, then you would need a $1,000 margin for a
$100,000 lot with a 100:1 leverage.
Let's say you have an account with $10,000 and you open that USD/JPY position. The broker-dealer
won't automatically close the trade if the losses exceed $1,000. The margin call will occur only when your net
balance is less than $1,000. So if the position goes against you and accumulates $9,001 worth of losses, your
position will be automatically closed and you will be left with $999 in your account.
Broker platforms already include the spread and the rollover into the equation, but remember that these
variables also influence the net balance.
4. Types Of Orders
To complete your view on the trading mechanics, let's cover the different order types that allow you
to enter, exit and program trades. There is a wide choice of orders designed for all types of trading styles.
Forex
Market Order
Orders that are executed immediately at current rates are known as market orders. For example,
suppose GBP/USD is currently traded at 1.5842; if you wanted to go long at this exact price, you would click
buy and your trading platform would instantly execute a buy order at that exact price.
When closing a position manually, the trader is also technically executing a market order of the same amount
in the opposite direction of the open trade. To close a long GBP/USD position, the trader only has to go short
the same size than the long position. This is also called an offsetting or liquidating transaction.
Limit Order
It's an order to buy or to sell at a specified price executed at the limit price or at a better price than the
market price. A sell limit order can only be executed at the limit price or higher, and a buy limit order can only
be executed at the limit price or lower. Note that a limit order can possibly not be executed because the
market price may quickly surpass the limit price before your order can be filled. This type of order is used as a
protection from buying the currency at a too high price or selling at a too low price.
Stop Loss Order

A stop loss order is a limit order preset to close out a position automatically when the bid or offer
price touches a given level with the purpose of preventing additional losses if price goes against you. In a long
position the stop loss will be set below the spread, and in a short position above the spread.
A stop loss order remains active until the position is liquidated or you cancel the stop loss order. For
example, if you go short USD/JPY at 107.00 you can limit your maximum loss by presetting a stop loss order
at 108.00. This means if the exchange rate moves up by 100 pips, your trading platform would automatically
execute a buy order at 108.00 and close out your position for a 100 pip loss.
If you have a long position instead, you may issue a stop loss order below the current exchange rate. If
the market price falls through the stop loss trigger price, then the order will be activated and your long
position will be automatically closed out.
Like limit losses, stop losses are useful if you don't want to sit in front of your trading platform all day. They also
prevent you from losing more than what you intended to in the case the Internet connection fails or if you
simply fall asleep.
Margin calls, as discussed before, can be effectively avoided by monitoring your account balance on a
very regular basis and by utilizing stop-loss orders on every open position to limit risk.
Trailing Stop Loss

A trailing stop loss is a stop loss order that is linked to a position like any stop loss, but instead of being
fixed at a certain price level, it has the capability to move as the position moves into profit. By raising the stop
loss trigger price, partial gains on the position are locked in.
Forex
Good Until Canceled (GTC)

Limit orders can be good for a specified time period (hours, days, months) or "good till canceled". A
GTC limit order is held open indefinitely (unless filled) and is only terminated on instructions by the account
holder.
A GTC order remains active in the market until you decide to cancel it. Your broker-dealer will not
cancel the order at any time. Therefore it's your responsibility to remember that you have the order
scheduled.
Good For the Day (GFD)

A GFD limit order is held open for the balance of the trading day unless it is filled before then. A GFD
order remains active in the market until the end of the trading day. Remember that the end of the day in Forex
is usually 5P.M. EST, but in any case double check with your broker-dealer.
One Cancels the Other (OCO)

An OCO order is a combination of two limit and/or stop-loss orders at opposite ends of the spread.
Two orders with price and duration variables are placed above and below the current price. When one of the
orders is executed the other order is canceled.
Example: The price of EUR/USD is 1.0050. You want to either buy at 1.0100 in anticipation of an up
move or open a sell position if the price falls below 1.0000. If 1.01005 is reached, the buy order is triggered
and the sell order is automatically terminated.
You can also use this type of orders when already in an open trade. For example, if you are in a long
position, the stop loss is placed below the entry price, right? In this case the OCO limit sell order would be
placed above the entry price. If the base currency rate breaches the OCO trigger price then the position will
automatically be sold and the original stop loss is canceled. Alternatively, if the rate falls to the stop loss
threshold, then the position will be closed out for a loss and the OCO limit order terminated.

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Study Material for Forex Trading

The Bretton Woods Regime, the Transition Era

Pegged, Semi-Pegged And Floating Condition

The system became an open US-Dollar-based world payments arrangement.

Let's define some of the concepts that we have learned so far:

2. Good Buy Bye Gold?

The Transformation Of Currency Exchange In The '70s

Speculative turnovers in currency exchange

Source: Bank For International Settlements

Scott Owens introduces the Forex by explaining:

3. The Market Structure

The Interbank Market

5. Advantages and Disadvantages

Instantaneous Order Execution and Market Transparency

Lower Transaction Costs

CHAPTER 2: The participants and their roles

A revival of Bretton Woods?

2. The Main Players In The Forex Market

Commercial And Investment Banks

Source: http://www.Euromoney.com forex survey

Businesses & Corporations

Fund Managers, Hedge Funds and Sovereign Wealth Funds

Internet Based Trading Platforms

Source: BIS.org Triennial Survey 2007

Online Retail Broker-Dealers

3. Doing Brokers Due Diligence

Main Regulatory Organizations

Costs: Fee And Commission Structures

Here is a checklist you can use in your due diligence:

Charter 3: Understand the Mechanics

1. Currencies and Currency Pairs

The Exchange Rate

USD (US Dollar)

GBP (Pound Sterling)

CHF (Swiss franc)

CAD (Canadian Dollar)

AUD (Australian Dollar)

NZD (New Zealand Dollar)

USD/SEK (US Dollar / Swedish krone)

USD/THB (US Dollar / Thai baht)

The formula for calculating the transaction cost is:

1. Currency Pairs With Direct Quote (EURUSD, GBPUSD)

2. Reverse Quote Pairs (USDJPY, USDCHF)

3. Margin and Leverage

Lots and Position Sizes

Margin Call- a Guaranteed Limited Risk

$10,000 $7,981 = $2,019 < $2,020 → margin call!

Stop Loss Order

Trailing Stop Loss

Good Until Canceled (GTC)

Good For the Day (GFD)

One Cancels the Other (OCO)

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