INTRODUCTION TO

FOREIGN EXCHANGE MARKET

TRADERS ADVISORY DMCC

Unit 1703, Indigo Icon Tower

Jumeirah Lake Towers, Sheikh Zayed Road
Dubai, UAE P.O Box 476460

Tel.: 971 4 447 5122

Fax: 971 4 447 5123

Email: [email protected]
Web: www.advisoryfx.com
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Risk Disclosure Statement

The content of this e book are for informational purposes only. No part of this publication is a
solicitation or an offer to buy or sell any financial market. Examples are provided for illustration
purposes only and should not be considered as investment advice or strategy.

The information found in this e book is not intended for distribution or use by any person o entity
in any jurisdiction or country where such distribution or use would be contrary to law or regulation
or which would subject us to any registration requirement within such a jurisdiction or country.

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Chapter 1: INTRODUCTION TO FOREIGN EXCHANGE TRADING

What is a FOREX Market?

T he foreign exchange market, which is usually known as Forex, FX, or

currency market, is a worldwide financial market providing the facility
to trade currencies around the clock, with exceptions of weekends.
Trading in currencies is the simultaneous buying and selling of currencies at
the same time. Trading in currencies started somewhere during 1970's, when
some of the countries in the world started to float their currency exchange
rates, diverting away from the previous fixed exchange rate regime.

The Forex market is a unique place which

offers trading in volume and in return
provides market liquidity. The geographical
dispersion of the market allows trading from
any corner of the world, providing 24 hours
of operation except the weekends. The
market offers you to utilize the leverage by
which you can enhance your profitability
with respect to the amount you can invest.

With the introduction of computers and then with the evolvement of the
Internet, currency trading on the Forex market has grown tremendously as
more and more people became aware of the profit potential that one could
make from this market.

The foreign exchange market is an over-the-counter market place which

means that there is no specific location where buyer and seller can actually
meet to buy and sell currencies. Instead, Forex trading is transacted over the
phone, fax, e-mail and through the websites of brokers who specialize in
currency trading.
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Advantages of Trading the FOREX Market

FOREX market offers a lot of advantages over other investment instruments.

Some of them are;

LIQUIDITY

One of the most important factors in trading is getting the right price.
The FOREX market provides liquidity which no other financial markets
offer, with the total daily trading volume of over three trillion US dollar,
it is very impossible to manipulate the market. Because of high liquidity,
you are guaranteed for an instant execution of your trade.

TRADING HOURS

This is the most attractive feature of Forex market. Trading is open for
24 hours and on all days except the weekends. This allows traders to
enter position from any part of the world. Currency trading takes place
continuously and unlike trading in stocks and shares, you do not need to
wait for an opening bell. It is market which practically never closes, and
you could trade at any time during the 24 hours from the comfort of
your home. This facilitates greatly if you want to be just a part-time
trader since you can choose your own time to trade.

TRANSACTION COST

The difference between the prices of buying and selling each pair of
currencies is termed as transaction cost. Forex market does not have
brokerage fees as is prevalent in securities market where there are
transaction costs as well as brokerage fees. Fees add up even when
discount brokers are used.

Choosing a FOREX Broker

Choosing a good Forex broker can be as complicated as Forex trading itself.

For that reason, investors should do their homework as diligently as they
would for a trade. Here are some tips to keep in mind to make your research
and choice easier.
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In the U.S., any worthwhile Forex broker will be registered as a Futures

Commercial Merchant (FCM) with the CFTC (Commodities Futures Trading
Commission). Finding one doesn't end the need for research, it's just the bare
minimum you should require.

Since Forex trades are highly leveraged (in effect, the broker 'lends' an
investor up to 99% of the money required to make a trade), the broker you
select should be associated with a firm with deep pockets.

Forex accounts are not FDIC (Federal Deposit

Insurance Corporation) insured, so you
cannot expect the U.S. government, or anyone
else, to bail out the brokerage firm or
reimburse you if the market turns sharply
downward. Large institutions, with ample
capital to withstand downturns in the
market, and rapid drains on their deposits if
clients withdraw en masse, are crucial to
your financial peace of mind.

Beyond those rock bottom basics there are many options.

Since the Forex markets trade 24 hours per day all around the world, you may
want to trade after normal business hours in your home country. Whether
your broker resides in the same country (usually, for language and legal
reasons) or not, you want one who will pick up the phone when you call.

Forex trading has moved into the Internet age, but it is still very much a
phone-based business. Getting a broker on the phone at any time of the day or
night can mean the difference between profit and loss. Sometimes, big profit
or loss.

Since Forex brokers don't work off standard commissions the way stock or
bond brokers do, you need to research the firm's spreads. Forex trading is
always done in currency pairs. A spread is the difference between the bid and
ask price - what the broker pays to buy versus the amount they sell a currency
for.

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Some brokers will offer fixed spreads on all trades, which have the advantage
of predictability. It's a kind of fixed 'commission'. But that may or may not suit
your trading style or your budget, since they tend to be larger than variable
spreads.

Any broker will offer a standard account to a qualified client. Typically you
have to fill out an application form that states you have adequate capital and
understand the risks involved in Forex trading. Standard accounts trade
currency in standard lots of 100,000 units. You can't buy 100 euros for $150,
you have to buy 100,000 euros.

Since that's a very large investment for the average trader, brokers offer
leverage. Professional traders use leverage as well, of course. In other words
you put in, say 1% of the total, the broker puts up the rest. That has huge
profit (or loss) potential, but it entails significant risk. So be aware of a
broker's margin call policy.

Many brokers today will offer some form of 'mini' account. Instead of trading
in standard lots, they trade in smaller units, such as 10,000. This lowers the
investment required from, say $2,500 to only $250. Most clients can easily
meet that minimum.

You'll want a broker with software that provides you with the research and
other trading tools you will need to be effective in Forex trading. Forex
investing is much more complex and volatile than even stock or bond trading,
which is already not simple when done well.

Be sure to use the trial accounts offered and make several 'fake' trades in
order to test out the software and research available. You need real-time
prices - Forex moves very fast - and lots of technical and fundamental analysis
information at your fingertips.

There are websites and forums where specific brokers are discussed, but take
what's said there with a grain of salt. Just as with complaints about vendors on
eBay or Amazon and other large Internet trading arenas, a few bad remarks
shouldn't ruin the reputation of honorable brokers.

Beyond all that, the factors become a little more difficult to judge. Above
everything, you want to feel you trust the person on the other end of the line.
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They are not there to be your friend or listen to personal complaints or trade
tips. But you should get the sense that they are competent, professional and
ethical.

Understanding Currency Prices

Forex trading is always about buying one currency and selling another one
simultaneously. The world of currency exchange, Forex (Foreign Exchange),
employs terminology not used elsewhere in the investment world. Defining
those terms, and providing a sample trade, will go a long way toward taking
the 'foreign' element out of foreign exchange.

Currency trading is always done in pairs. In other trading, such as stocks and
bonds, cash is exchanged for something else (a percentage of ownership, a
promise to pay interest).

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In Forex, cash is traded for cash. Euros are traded for dollars, dollars for yen,
yen for euros and so on. There are dozens of trading pairs, just as there are
dozens of currencies around the world that participate in the currency
exchange markets.

The major players are US Dollar (USD), Euro (EUR), Australian Dollar (AUD),
British Pound (GBP), Canadian Dollar (CAD), Japanese Yen (JPY) and Swiss
Franc (CHF). Most of all daily transactions involve trading of these major
currencies.

Mechanics of Buying and Selling

Trading in foreign currencies is buying one currency at a given exchange rate

and selling off the currency bought under a favorable currency rate which may
fetch you with profits. When you are buying a certain currency you would
hold on to that currency till you find that the exchange rate is appreciating in
value relevant to the other currencies when you would sell off your bought
currency to make a profit.

You could also take a long/buy position in

EUR/USD. This would mean that you are
selling off your USD to buy GPB with an
expectation the exchange rate for EUR as
against USD would appreciate. On the other
hand if you should take a short/sell position
with the same currency pair, you would be
selling off your EUR and buy USD if you are convinced that the exchange rate
would decline.

Understanding FOREX Quotes

There are two types of currency pairs, Direct and Indirect.

In direct quoted currency pairs USD is the quote currency or the second
currency in the pair. As for indirect quote, USD becomes the first currency or
the base currency.

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Bid and Ask

The 'bid' is the price at which brokers are willing to buy the base currency.
The 'ask' price is that at which brokers are willing to sell the base currency.

The quotes are always listed from the brokers' point of view. So if you (the
trader) wants to buy the base currency the ask price will apply. If you (the
trader) wants to sell the base currency the bid price will apply.

EUR/USD 1.1901/03 means

If you buy 1 EUR you will pay 1.1903 USD

If you sell 1 EUR you will receive 1.1901 USD

GBP/USD 1.7439/42 means

If you buy 1 GBP you will pay 1.7442 USD

If you sell 1 GBP you will receive 1.7439 USD

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So, when reading quotes, investors will see prices listed as:

Pip and Spread

The difference between bid price and ask price at a single specific time is
called 'the spread'. The spread is measured in pips (price interest points). The
'pip' is often said to be the smallest increment by which the price changes.

If the bid price of the EUR/USD pair changes from, say, 1.1901 to 1.1902 that's
a single pip. That's a (bid or ask) price at two different times. Remember not
to confuse this difference with the spread, which is a difference between the
bid and ask price at a single, specific time.

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Forex market makers and brokers make money from the spread. It's
important you understand how it works.

Suppose a trader is dealing directly with a market maker. A market maker is

an individual or company that directly offers a currency pair trade, as
distinguished from a broker who acts as an intermediary. The bid price is that
which the market maker offers to BUY the base currency from the trader. The
ask price is that which the market maker requires in order to SELL the base
currency in exchange for the quote currency.

For example

EUR/USD 1.1900/05 means

If you buy 1 EUR you will pay 1.1905 USD

If you sell 1 EUR you will receive 1.1900 USD

The difference between those two prices is now the SPREAD and it is how
market makers (and, indirectly, Forex brokers) make a profit, instead of
charging commissions. In practice, for every seller there must be a buyer for
any trade to take place. The broker, acting as an intermediary - unless he or
she is also a market maker buying and selling for his or her own account -
locates a trading partner.

If you are willing to sell euros at the exchange rate of $1.1900 the broker
locates someone willing to buy them at $1.1905. The broker pockets the
difference, instead of receiving an explicit commission.

How does this affect you, the Forex trader? You are paying for the spread, in
essence.

Suppose you were to accept the trade and sell euros for dollars. The bid price
will apply so you receive 1.1900 dollars for every euro sold. Now suppose you
wanted to immediately buy those euros back from your broker. The ask price
will apply so you would pay a rate of 1.1905 dollars for every euro acquired.
That difference, the spread, is measured in points or pips, in this case 5 pips.
That five point difference would result in an immediate loss to you, even
though the exchange rate hasn't changed by a single pip. You sold euros for 5
pips less ($1.1900) than you bought them for ($1.1905).
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It's perfectly legal and ethical. It's simply the cost (to you) of trading in foreign
currency.

Calculating the Value of a Pip

When-ever you open a position, your profit or loss is calculated on the basis of
Pips at the time you close your position. Suppose you have opened a position
on EUR/USD currency pair which moved from 1.4210 to 1.4220. To
understand how much in dollar you have made on this deal, you would need
to find out the value of a Pip in this regard, and also how a 10 Pip movement
affects your investment. The formula for direct quoted currency is as follows:

In the above example the Pip value will always be $10 where the standard lot
size is $100,000. Therefore, if you were trading and if the Pip value moved by
5 points in your favor, you would stand to gain $50.

Take for example that you have opened up a position where the rate for
EUR/USD pair is 1.4215, which means that for every Euro you need to pay
$1.4215.

First Step: (0.0001/1.4215) X 100 000 EUR = 7.03 EUR

You would need to find out the value of Pips in US dollars, and for this the
following step is necessary.

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Second Step: EUR 6.44 X EUR/USD Exchange rate = 6.44 EUR X 1.5515 =
9.9916 $, which after rounding up will be $10 per Pip.

If USD is mentioned as the first currency in a pair or is a directly quoted

currency, you just need to follow the following instances.

In case of USD as the base currency, suppose the rate for USD/CHF is 1.0780
(It means, that 1 USD costs 1.0780 CHF), the value of a Pip would be
(0.0001/1.0780) X 100 000 $ = 9.28 $ per Pip. In case the currency pair is
USD/JPY, suppose the rate for USD/JPY is 101.05 (It means, that 1 USD costs
101.05 JPY), the value of a Pip would be (.01/101.05) X 100 000 $ = 9.90 $ per
Pip.

Note that in the usual case a Pip is usually 0.0001, and in case of Yens it is
0.01.

Margin and Leverage

Leverage is a kind of loan that your broker might provide you with which may
go up to 90% of the total amount. In this way leverage gives you the facility to
have more control than what you actually have. At times a broker may provide
leverage which can go up to 400:1, which would mean that you require only
1/400 or 0.25% as 'good faith deposit' to avail the facility. Most of the brokers
offer 100:1 leverage, where you need to deposit 1% in order to open a
position.

Suppose your broker offers a 1% margin. That means you put up 1%, the
broker loans you the other 99%.

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So when purchasing 1 standard lot of 100,000 units of euros for $119,030 the
investor has to provide only $1, 1903 of his own cash. The broker provides the
rest.

Cautionary Tale of Margin Call

The broker may ask a trader for additional margin money when it is found
that the balance in his trading account, which is required for the trader to
open a position, has fallen below the maintenance margin, this is what we call
the Margin Call.

Let us take another scenario;

You bought Euros speculating that the euro was undervalued against the US
dollar. So you estimate the price of a euro will rise in the future, from 1.1903
to say 1.2000 and eventually it does. But before that happens the price falls,
temporarily, to 1.1800. It loses '100 pips'.

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Of course, at this stage no one knows how long 'temporary' is, nor whether the
price will fall further or rise to your target selling price. By the time you fall on
your maintenance margin requirement, your broker, not knowing your credit
worthiness or simply having bills of his own to pay, decides to cut his losses
and liquidate your position. So he sells your Euros for dollars and declares for
you, without your prior knowledge or permission, a loss.

Base on the above situation, once your account fall below the maintenance
margin and if you dont put more money to meet the required margin, the
broker will close some or worst all of your positions.

Brokers are entitled to do this, legally and ethically. They make no

commission from you - they profit from playing spreads - and they are loaning
you large sums of money for, in essence, zero interest.

Different Types of Orders in the Market

The Forex market provides different kinds of orders for trading. Some of the
major order types are given below -

MARKET ORDER

Market order is the one which is placed by the trader at the current
prevalent price at that particular time. One needs to understand the
word 'current' as regards to currency trading. The current price in
Forex market changes even faster than the price in the stock market.

In the inherent high volatility existing in currency trading, a market

order may deviate from the price shown immediately on the screen of
the trader. As far as the stock market is concerned, a stock trader raising
a market order to sell a definite share at $28.25 may expect the price
quite often. In case of the Forex market, the chances to sell the currency
exactly at the price shown on the screen are very small.

LIMIT ORDER

Quite often a trader puts a limit to the sale value of his currencies. The
trader issues a limit order that would guarantee that his currencies will
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not be sold for less than the limit he has mentioned, or buy for more
than the limit price set by him. Forex brokers would never guarantee
transaction execution at an exact price, though this has known to
happen.

Suppose the British Pounds (GPB) has a current rate of $1.7750 which
appears to be a bit high for you. So you put a limit order to buy GPB at
$1.7705. This in effect tells the Forex broker that you do not wish to buy
GPB at a price more than $1.7705.

In another example, let us assume that you had bought Euros at

$1.1905, and consequently the market price increases to $1.1955.
Placing a limit sell order on your Euros at, say $1.1945 would allow you
to lock in a minimum profit of 40 pips or better.

STOP ORDER

Traders in Forex market often use a stop-loss order, which is used

primarily to stop losses. When a stop-order is issued after a limit-order,
the trader is trying to prevent his losses. His limit-order indicates that
he wishes to buy or sell currency at a price not less than the price he has
set. A stop-order specifies that the trader wants to buy or sell when the
market is offering a given specific price, which is usually called 'stop
price'. After the price has reached the specific price set by the trader, the
trade becomes a market-order and is subjected to fluctuations, and by
the time the trader buys or sells, the price may be different from the one
that the trader specified.

A stop-order has its advantages. The trader does not have to monitor
the currency price movement on daily basis. However, stop-order has
its disadvantage too. The stop-price could get activated by short-term
fluctuation in a currency price.

In order to understand stop-order, let us suppose that you pay by USD

to buy EUR. The exchange rate when you bought Euros was $1.1888.
Consequently you observe that the market price is on its way down. You
would need to protect your losses, and therefore you put a stop-order in
order to prevent yourself from having to input more cash to cover the
equivalent of a margin call, or enduring an even larger loss.
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By putting a stop-order you are instructing your broker to sell your

Euros when the exchange rate has reached $1.1803. By this, as soon as
the price reaches $1.1803, your Euros would be sold at market price
which would save you incurring further losses.

ONE CANCELS THE OTHER (OCO)

Understanding that the currency market is very volatile, a trader would

put OCO to reduce, as much as possible, the effect of market volatility on
his trade. OCO is an order which, as the name suggests 'Cancels-The-
Other orders'. The trader has put a combination of two orders in which
the other one gets automatically cancelled if one is executed. Suppose a
trader has placed a stop-order at 1.4575 and a limit order at 1.4725
simultaneously. If the first one gets executed, the limit order
automatically gets cancelled, and vice-versa.

GOOD TILL CANCELLED (GTC)

GTC is an order put by the trader where he wants the order to remain
till it is cancelled by him. This kind of an order is linked to an already
existing order which remains open till the order is cancelled when the
trader issues an instruction of cancellation to his broker. It is up to the
trader to remember that he has a pending order in the market.

GOOD FOR THE DAY (GFD)

GFD is also an order which is linked to a pending order put by the

trader. GFD instructs the broker to cancel the pending order if the
conditions are not met by the end of the day, which is usually 5:00 pm
EST in the Forex market.

TRADING TIME

The Forex market is open 24 hours a day for 5+ days a week. The market
opens on Sunday afternoon EST and closes on Friday afternoon EST. The
trading virtually starts at Sydney, and then onwards moves to the different
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financial centers in the world, for example, Tokyo, London (and Europe), New
York. The market's daily session for daily charting purposes closes at 5:00 PM
(coincident with the New York close), but the market does not actually close.

When the market closes for the day in one part of the world, it opens in
another, and this closing and openings over-lap in such a way that the Forex
market appears to be open 24 hours a day.

It is very important for you to know the different market session timings in
order that you, as a trader, can get the full advantage of the activities going on
through-out the 24 hour session. This would provide you with greater
opportunities to trade. Timing is one of the most important factors in
currency trading. With liquidity in the market depending upon the various
geographical locations, timing of trading makes a lot of difference.

Trading in Asian Session

The 2004 BIS Survey states that the trading volume in the Asia-Pacific session
constitutes 21% of the trade that takes place globally. The principle cities

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where financial trading takes place are - Wellington, New Zealand; Sydney,
Australia; Tokyo, Japan; Hong Kong and Singapore. Much of trade takes place
based on Japanese data coming to the market, and during the time trading
takes place in the Asia-Pacific session, most of the attention is towards
currency pairs USD/JPY, EUR/JPY and AUD/JPY.

Tokyo is the first market in the session to open, and this center remains one of
the most important centers in the Asian market. This is the reason why many
of the traders often use the advantage of the momentum that this market
helps to gather, and from this momentum traders are able to speculate the
market dynamics during the day's session.

Trading in European/London Session

The Asian market has now been open half a day and around mid-day the
European market starts to open up their trade. The European financial market
and the one in London account for over 50% of volume in trading during the
day, and as par the 2004 BIS survey, London alone account for about one
third of total daily global volume. This makes the London center as one of the
most important and largest dealing centers in the world.

The European market is considered to be at its absolute peak during its

session. The reason is because the market spans through half of the Asian
trading day and half of the North American trading session, which makes the
European market an interesting center for traders. The market offers one of
the best active and moves in European currencies, Euro, GPB and CHF.

Trading in US Session

The market session in the US provides practically the same volume of

business as in the Asia-Pacific market, and this is about 22% of globally traded
volume. New York is the second largest Forex market place, and because of
the overlap between North American and European trading sessions, the
trading volumes are significant. Some of the biggest and most meaningful
directional movements take place during this crossover period.

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Market uncertainties creep in as the London and the European markets close.
The closure generates volatile environment and introduces uncertainty in the
market trends. For example, a directional move that was introduced in the
market during Asian and European trading or earlier of New York session may
get reversed if enough traders decide to take their profit away. Most of the
currency pairs which are quoted are EUR/USD and USD/JPY, and these
become very volatile during this period.

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