Understanding Currency Quotes

In the forex market, all price quotes are represented by two prices, known as the bid price and the ask price. Both the bid price and ask price represent the exchange rate of the base currency pair against the quoted pair, except they serve two different functions. The bid price indicates the price at which your currency dealer is willing to buy the base currency from you in exchange for the quoted currency. The ask price indicates the price at which your currency dealer is willing to sell you the base pair in exchange for the quoted currency. There is always a difference between the bid price and the ask price; this difference is known as the spread. The spread is usually less than five pips on major currency pairs. Cross-currency pairs such as GBP/JPY may have much higher spreads. The spread is the way a currency dealer earns money for executing a trade.

Figure 1.2 shows the difference between the bid and ask prices offered in the forex market. The difference between the two prices is known as the spread.

Using the prices quoted in Figure 1.2, if a trader wanted to buy EUR/USD, his currency dealer would sell it to him using the ask price of $1.4002. To sell the position at least at breakeven, the trader needs the bid price to move up two pips, to $1.4002. Alternatively, if a trader wanted to sell the EUR/USD, the currency dealer would sell it to him at the bid price of $1.4000 and the trader would need the market to fall by two pips before he could sell it at the ask price for a breakeven trade. The two-pip spread in this EUR/USD example is the cost of doing business with this currency dealer.
















FIGURE 1.2 Understanding Price Spreads MetaTrader, © 2001–2008 MetaQuotes Software Corp.

Long versus Short

The terms long and short simply refer to the position a trader has taken with a trade; the trader has either bought or sold it. The term long simply means that you have bought the currency; the term short means you have sold it. For example, if a trader decides to buy GBP/USD, it means she has gone long British pounds and short U.S. dollars because she has bought the GBP and sold the USD.

TABLE 1.5 Mechanics of a GBP/USD Currency Trade

What Is a Pip?

The term pip is an acronym for percentage in points and is used to measure the change in exchange rates on the forex market. A single pip represents the smallest possible decimal change a currency quote may move, and it is the standard on which profit and loss are calculated. Currencies are quoted in decimal format to 1/1,000th of a percent unless the currency pair contains the Japanese yen. Currencies quoted against the Japanese yen are in decimal format to 1/100th of a percent. Using a quote for GBP/USD as an example, a change in price from $1.5600 to $1.5650 represents a change of 50 pips.

What Is a Pip?

The term pip is an acronym for percentage in points and is used to measure the change in exchange rates on the forex market. A single pip represents the smallest possible decimal change a currency quote may move, and it is the standard on which profit and loss are calculated. Currencies are quoted in decimal format to 1/1,000th of a percent unless the currency pair contains the Japanese yen. Currencies quoted against the Japanese yen are in decimal format to 1/100th of a percent. Using a quote for GBP/USD as an example, a change in price from $1.5600 to $1.5650 represents a change of 50 pips.

How a Currency Trade Works

The way a currency is simultaneously bought and sold during a trade is confusing for many new traders, so an example will help clarify what happens under the hood of a currency trade. Assume for a minute that you are interested in buying the British pound against the U.S. dollar, which is listed as GBP/USD in your trading software. The base pair is the British pound; the quoted pair is the U.S. dollar. If the quoted exchange rate is $1.59 and you are trading one standard lot of currency, it will require 159,000 dollars to buy one British pound, or it will require selling 100,000 pounds to buy 159,000 dollars. Since we are interested in buying the pound, we want the exchange rate to increase, allowing us to sell our pounds at a higher rate for more dollars than we sold to buy the original 100,000 pounds. As an example, Table 1.5 illustrates how a currency trader realizes a profit or a loss using a single standard lot GBP/USD currency trade.

How a Currency Trade Works

The way a currency is simultaneously bought and sold during a trade is confusing for many new traders, so an example will help clarify what happens under the hood of a currency trade. Assume for a minute that you are interested in buying the British pound against the U.S. dollar, which is listed as GBP/USD in your trading software. The base pair is the British pound; the quoted pair is the U.S. dollar. If the quoted exchange rate is $1.59 and you are trading one standard lot of currency, it will require 159,000 dollars to buy one British pound, or it will require selling 100,000 pounds to buy 159,000 dollars. Since we are interested in buying the pound, we want the exchange rate to increase, allowing us to sell our pounds at a higher rate for more dollars than we sold to buy the original 100,000 pounds. As an example, Table 1.5 illustrates how a currency trader realizes a profit or a loss using a single standard lot GBP/USD currency trade.

Currency Lots

Currencies are traded in standard lot sizes to facilitate efficient trading on the forex market. The standard retail lot is 100,000 units of the base currency. Most currency dealers offer 10,000-unit mini lots and 1,000-unit micro lots. Some currency dealers offer a 100-unit nano lot. Positions can be sized larger by purchasing multiple lots. Fortunately, you don’t actually need $100,000 in your trading account to buy a single standard currency lot. Currency dealers offer various levels of leverage, allowing you to control full-sized lots with significantly less capital in your account. We discuss margin and leverage later in this chapter.

Currency Lots

Currencies are traded in standard lot sizes to facilitate efficient trading on the forex market. The standard retail lot is 100,000 units of the base currency. Most currency dealers offer 10,000-unit mini lots and 1,000-unit micro lots. Some currency dealers offer a 100-unit nano lot. Positions can be sized larger by purchasing multiple lots. Fortunately, you don’t actually need $100,000 in your trading account to buy a single standard currency lot. Currency dealers offer various levels of leverage, allowing you to control full-sized lots with significantly less capital in your account. We discuss margin and leverage later in this chapter.

Currency Pairs

Each currency pair is made up of two parts: the base currency and the quote currency. For example, the U.S. dollar/Canadian dollar example we just discussed is paired as USD/CAD. The base currency is always to the left of the slash (/) mark; the quoted currency is always to the right of the slash. It is the direction of the base currency you consider when deciding whether to buy a currency pair or sell it. If you believe the base currency will appreciate against the quoted currency, you will buy the currency pair. If you believe the base currency will depreciate against the quoted currency, you will sell the currency pair. This is an important distinction for new traders to remember because it is easy to buy by accident when you meant to sell. Currency pairs offered on the forex market are constructed using currency from both developed and emerging markets.

Table 1.4 lists the most common currencies, their countries, and their International Standards Organization (ISO) codes used in the forex market to construct currency pairs.













TABLE 1.4 Currency Pair Basics

Major Pairs Major currency pairs are created by pairing currencies from countries with highly developed economies and financial systems. Major currency pairs are the most liquid and heavily traded currency pairs on the forex market. Currencies among the majors include the euro, U.S. dollar, British pound, Swiss franc, Japanese yen, Australian dollar, and Canadian dollar.

Cross-Pairs Some currencies are not directly quoted against each other; rather, they are synthetically traded by combining two different pairs. These pairs, known as cross-pairs, include currency pairs such as GBP/JPY, EUR/JPY, EUR/CHF, and GBP/CHF. When a trader executes a trade to buy GBP/JPY, the trade is really constructed by buying GBP/USD and selling USD/JPY. The dollar component of this trade is equaled out and the trader ends up long GBP and short JPY. Because these pairs are constructed with two different currency pairs, the spread or cost to trade a
EUR/USD. cross-pair is significantly more than a typical major currency pair, such as

Trade Mechanics

Trading currency is a process of exchanging one currency for another, so each currency trade is actually two transactions happening at the same time. One currency is bought while the other is sold. The forex market quotes prices as currency pairs to facilitate the ease of trading one currency for another. The quote of a currency pair represents the number of units nof one currency that are required to buy or sell the equivalent amount of the other, based on the given exchange rate. For example, if the exchange rate between the U.S. dollar and the Canadian dollar is $1.12, a trader may purchase 1.12 Canadian dollars for every one U.S. dollar, or she can buy one dollar for every 1.12 Canadian dollars. Your goal as a currency trader is to hold the currency you believe will gain value against the other currency quoted in the pair. It really is as simple as that.

Trading Hours

The forex market is a global marketplace and trades 24 hours a day, five days a week. This around-the-clock trading environment is not unique to the forex market but certainly does make it easier to manage trades around a schedule that fits your lifestyle rather than certain market hours. In the United States the forex market begins trading Sunday evening as Asian markets open for business and continues to trade until the New York markets close on Friday afternoon. However, just because the market is open 24 hours a day doesn’t necessarily mean anything interesting is happening.

There are three major trading sessions that account for the majority of volume seen throughout the trading day. The largest trading session by volume is the London session. London is uniquely positioned in a time zone that’s open for business during work hours stretching from Dubai to New York. The London trading session accounts for the most price action and volume in the forex market by a long shot. New York follows London as the second largest trading session; Tokyo, or the Asian trading session, rounds out the top three.

Table 1.3 lists the three major trading sessions in the forex market and the times during which they are active. The times are listed in Eastern Standard Time.

Many trading strategies depend on the activity seen during the highervolume trading sessions. For many traders who work at day jobs, it is impractical to trade during a trading session that happens while they sleep or are at work. This book focuses on placing trades around supply and demand levels during the quiet times of the market, around your schedule. It is better to plan and enter long-term trades during the quiet hours of the market and leave the trading sessions to day traders who enjoy staring at charts all day.










TABLE 1.3 Trading Session Timetable

Transaction Costs

Currency dealers heavily advertise that there are no commissions for trading currency, but that doesn’t mean the forex market is cheap to trade. Currency dealers earn their money through the spread, which is the difference between the price at which a dealer will sell a currency and the price at which the dealer is willing to buy it back. For most major currency pairs, the spread is very small, but the costs associated with that spread vary depending on the margin and leverage your account has used.

You’ll learn more about currency pricing shortly, but for now understand that the transaction costs of trading currency on the forex market can be significant. For traders who trade frequently, transaction costs can be a significant amount of money to overcome to reach profitability. Fortunately the forex market is a fast-moving one, and once you clear the price of the spread there are no further transaction costs. The more interbank trading partners a currency dealer has, the better that dealer’s pricing will be. Dealers with more than one or two interbank partners are able to take advantage of more quotes and pass them on to you.

Table 1.2 illustrates the difference in transaction costs for trading 10 different contracts across various market types. Although there is no commission, the forex market is certainly not a cheap market to trade. These prices were taken from the published commissions of a major broker’s web site. The cost of the currency spread assumes a euro/U.S. dollar transaction using leverage of 100:1.










TABLE 1.2 Transaction Costs Across Market Types

Contract Flexibility

Trading on exchange-based markets and the forex market is conducted in standard contract or lot sizes. Unlike the exchange-based market, the forex market doesn’t set restrictions on the size of a single contract. Theoretically you could place a single trade worth $1,384,284,927,944.01, assuming that you can find someone able and willing to take the other side of your trade—Dr. Evil, perhaps? Currency dealers on the retail market have carved up a standard $1 million interbank lot into three smaller lot sizes accessible to smaller retail traders, known as standard lots, mini lots, and micro lots.

Standard lots on the retail side of the currency market are equal to 100,000 units of the base currency. Mini lots are equal to 10,000 units of the base currency; micro lots are equal to 1,000 units of the base currency. Some currency dealers even offer trades in single units, allowing a trader to place an order for 13,428 units rather than a conventional lot size. This gives the trader very precise position sizing capability that’s unavailable in traditional exchange-based markets. A unit might be a single dollar, euro, yen, or whatever the denomination of your account. For example, a trade of 10,000 units is synonymous with a $10,000 position if your account is denominated in U.S. dollars.

Micro accounts offer new traders the ability to trade real money without placing a tremendous amount of money at risk. Typically a micro account measures profit and loss in terms of a single dollar per pip or even less, depending on the margin requirement deployed. These small lots are a great place for a new trader to cut his teeth on live money trading once he has demonstrated he can trade profitably on a demo account. They are also useful accounts for testing theories with a live money account. I keep a micro account with less than $1,000 in it for testing strategies on live markets with live money. Overall, micro accounts are a great option to get started with, even if you have $100,000.

No Trading Restrictions

Freedom to trade in whichever direction you see fit at any time you see fit is a key feature of the forex market. For years the Securities and Exchange Commission (SEC) enforced a rule against short-selling stocks known as the uptick rule. The uptick rule attempted to prevent speculators from intentionally driving down the value of a stock with relentless short selling. Under the uptick rule a trader could only sell a stock if the current price was above the sale price, or on an “uptick.” Once a stock was falling, traders could not sell the stock again until the next uptick. Although the uptick rule was suspended in June 2007, there have been plenty of calls to reinstate it following the relentless stock market selling in 2008 and 2009. The forex market has no restrictions on trading. If you believe the euro will fall against the dollar, you can sell it without restrictions. Currency traders are able to move in and out of positions freely, without an uptick rule or other regulatory restrictions.

Having no restrictions on trading can also be a negative factor of the forex market. Since the market is unregulated and there are no restrictions on trading activity, the environment for manipulation exists. An extreme example of manipulation is the intervention by central banks. Intervention is a process of buying or selling tremendous amounts of currency to manipulate the exchange rate. The Bank of Japan has a history of intervening in the yen when its central bankers are displeased with the exchange rate. Manipulation can take many forms, from intervention to requoting a trader’s order to favor the dealer’s books. You should be aware of the risks involved with trading off-exchange in the spot market before you commit any live money to a trade. It’s called the Wild West of trading for good reason.

Little Regulation

The forex market has been known as the “Wild West” of financial markets due to the lack of regulatory oversight. The global nature of the forex market presents a problem for local government agencies to police trading activity around the world. Currently there are no regulatory requirements for an institution to establish itself as an interbank participant; however, any reputable retail currency dealer will register voluntarily with the local regulatory agencies. We already pointed out the CFTC has new regulatory authority over the off-exchange retail currency market through the 2009 Farm Bill. As I write this, the CFTC is proposing new regulations that would require all dealers to register as members of the NFA.

In the United States, the National Futures Association (NFA) has begun implementing rules designed to protect currency traders, although some of its recent decisions have been met with skepticism. In 2009, the NFA banned a practice known as hedging, which allowed a currency trader to maintain opposite positions in the same currency pair, and implemented order execution rules, forcing changes in some dealers’ trading platforms. Although the rules are designed to make trading operate closer to the futures and equity markets, some traders resent the presence of regulators making changes to a market that has been self-regulated since its creation.

Forex Versus Exchange Markets

The forex market is not structured like a traditional exchange market such as the New York Stock Exchange or the Chicago Mercantile Exchange. Forex is a decentralized global marketplace where trades are cleared one on one between trading partners. There is no central exchange, no pit full of yelling traders, no big board of quotes on a New York street, and no closing bell to ring. The pros and cons of an exchange-based market versus off-exchange currency trading are debatable, but there are obvious differences you should understand before trading in the forex market.

No Transparency

One clear advantage of an exchange-based market over off-exchange currency trading is the transparency the exchange offers traders about the market. Exchanges clear every trade through a central exchange, allowing them to provide traders with a wealth of information about the market activity. Common tools such as order flow and volume data are displayed on trader’s charts, allowing them to gauge the strength or weakness of price moves throughout the trading day.

Because the forex market is decentralized, there is little data available on market activity. Market makers and retail dealers typically do not share their order flow data, and those that do only represent their trading desk activity and not the forex market at large. Volume is another popular indicator used by stock and commodity traders on exchange markets that is unavailable in the forex market because there is no central exchange on which to measure volume. Currency traders must learn on their own to read price action through their charts, without the aid of exchange-based indicators.

Retail Speculators

Retail speculators may be trading their own account or client funds through a managed account program. Some speculators at the retail level may be trading for clients looking to hedge risks; however, most are looking to generate profit. Retail speculators are too small to trade directly on the interbank and clear their trades through one of the many retail dealers available to make a small-volume market for them. For the most part,retail speculators represent people like you and me, trading small-volume accounts purely for the sake of making a profit. The number of retail speculators involved in forex worldwide continues to grow as the popularity of currency trading grows.

Retail Currency Dealers

The average retail trader doesn’t have the credit or capital required to participate directly with interbank trading partners. Retail currency dealers act as market makers for small-volume currency traders. Currency dealers manage their risk by balancing their portfolios of retail orders among the customers for which they are making a market. When they are overexposed to market risk due to an imbalance of short or long orders, they offset their risk by taking positions with their trading partners on the interbank. It is important to understand that currency dealers do not operate the same way stockbrokers do. The spot currency market does not have an exchange; therefore, the currency dealer often fills a customer’s order by itself assuming the risk. This is commonly known as taking the other side of the trade. In other words, the currency dealer is betting against your ability to make money. If you lose, the dealer wins and collects the spread for doing the transaction. This is significantly different from a stockbroker, who is paid a commission for brokering your order to the exchange, where it is matched with an anonymous third-party order on the exchange.

There is an inherent conflict of interest when your dealer is profiting by taking the other side of your trade. Traders have historically complained about poor order execution, excessive quoting, or stops being “gunned,” and there is probably some basis for these complaints. Forex after all is an unregulated market, and shady dealers do exist. Currency dealers are aware of these perceptions as well and are now marketing no dealing desk execution or direct interbank trading as an alternative order execution strategy to taking the other side of the trade. These trading platforms suggest the dealer is not involved with your trade, and passes the order directly to a trading partner. Whether every order is matched anonymously or not is a matter of trust, but it doesn’t hurt to do business with a dealer who offers an alternative to taking the other side of every trade.

Central Banks

Central banks play an important role in guiding the forces of supply and demand for a country’s currency on the forex market. Their monetary policy statements, interest rate decisions, and ability to intervene in the forex market should make every trader pay close attention to their actions. Central banks are also tasked with controlling the money supply of a nation’s currency, which directly affects supply and demand. Low supply and high demand tend to increase the value of a nation’s currency, whereas high supply and low demand will devalue it. Balancing growth with inflation is the typical goal of central bank policies. Central banks may also change their overnight lending rates as a tool against inflationary pressures. The interest rate set by a central bank can influence the value of a currency based on yield. The higher the central bank rate, the higher becomes the yield for holding that currency, influencing demand.

Table 1.1 lists the central banks and their Internet addresses for major currencies traded on the forex market.










TABLE 1.1 Central Banks around the World

Institutional Traders

Institutional traders represent corporations or hedge funds trading directly on the interbank or through retail currency dealers. Hedge funds may participate as speculators while corporations participate to protect their interests against exchange risk. Corporations conducting business globally face a potential issue of fast-moving exchange rates, devaluing their profits made overseas. These corporations may participate in the currency market by hedging their risk directly in the currency market rather than waiting for a bank to exchange the currency for them. Most institutional traders representing corporations are involved in some kind of hedge to protect the value of their goods or services from exchange-related risks. Institutional traders may include professional money managers looking to diversify and hedge against the risk of loss in the equities market.

The Interbank

Interbank is a loose term held over from the early days when banks traded for clients and themselves over the telephone. Today trading is conducted electronically, with quotes from buyers and sellers matched up on the interbank market automatically. Many interbank members act as market makers for the currency pairs traded on the spot currency market and offer the quotes that ultimately drive the pricing you see in your trading software. Among the largest market makers on the interbank are banking giants such as Citigroup, UBS, Goldman Sachs, and Deutsche Bank. Lehman Brothers was a major interbank market maker prior to its demise in September 2008.

Participants on the interbank are big-dollar players, since the lowest accepted trade size is set at an even $1 million. It isn’t uncommon for orders larger than $100 million to be executed on the spot forex market due to the global size and liquidity of the interbank market. Many banking participants on the interbank fill orders for customers who actually intend to take delivery of the currency being traded; however, most interbank members also trade the bank’s money as speculators attempting to make a profit just like any other currency trader. The advantage interbank market makers have over a regular retail trader is access to order flow information. If you are the market maker and you see all the orders, you have insider information about the direction of the prices. Taking a trade against that information provides a significant source of revenue for many financial institutions.

Interbank members trade only with partners with which they have arranged credit agreements. This is an important point to understand because it affects the pricing you receive from your currency dealer. The quotes flowing from interbank trading partners ultimately drive the pricing you see through your currency dealer’s trading software. The more trading partners a dealer has, the more quotes at which they can execute a trade, resulting in more competitive pricing for you. You should look for a currency dealer with multiple liquidity feeds.

Forex Participants

Forex has a diverse population of participants, ranging from Japanese housewives to powerful central bankers. The objectives of the participants differ, and their individual actions may have dramatic affects on the market. It is important to remember that the forex market is an offexchange marketplace; there is no central exchange where all orders are cleared, as on the New York Stock Exchange or the Chicago Mercantile Exchange. The bulk of trading is done between trading partners on the interbank; however, small retail traders are unable to trade directly with partners on the interbank. Therefore, some participants in the forex market exist to create a marketplace for others. Currency dealers create a market for smaller retail speculators and offset their risk by trading with their larger partners on the interbank. The hierarchy of forex participants is illustrated in Figure 1.1. There is a definite food chain among forex market participants, with interbank members on top and retail speculators on the bottom.

FIGURE 1.1 The Flow of Forex Market Participants

Forex Roots

The roots of our modern forex market are an interesting topic that has been covered ad nauseum by other trading books; however, I do believe it is important to have some knowledge of the market’s history, so this section covers the key points. If you have never studied global monetary systems, consider this section an abridged history of the forex market. The modern forex market’s roots began with over-the-counter currency trading desks established by banks throughout the 1970s and 1980s, following the collapse of a postwar-era monetary system known as the Bretton Woods system. Bretton Woods was established in June 1944, as World War II came to a close. The Allied nations sought to establish a new monetary system to promote global investment and capitalism and to eliminate the challenges of a gold standard system.

Under the Bretton Woods monetary system, member nations agreed to value their currency at parity to gold ±1 percent and then set their exchange rate against the U.S. dollar. In exchange, the United States agreed to peg the dollar against a gold standard of $35 per ounce and guarantee its exchange for gold. This promise by the U.S. government effectively made the dollar a global payment standard instead of using a gold standard. The phrase “good as gold” was frequently used to describe the U.S. dollar under the Bretton Woods monetary system. Although the system worked to foster investment and capitalism, it also encouraged a tremendous outflow of dollars into overseas currency reserves. The world needed dollars to support a global payment system based on the dollar, and the United States was content printing more money. The United States assumed it could balance the deficit with trade. Unfortunately, the outflow of capital finally caught up to the Unites States in 1950 and the country began posting a negative balance of payments, despite the government’s best efforts to increase trade.

As inflationary concerns loomed on the horizon, the United States found itself in a difficult position. Failing to supply the global demand for dollars would bring the monetary system to its knees, whereas continuing to print money would eventually threaten to devalue the dollar. Confidence in the U.S. government’s ability to maintain a gold match standard for the dollar began to wane, and speculation grew that a serious devaluation in the world’s primary reserve currency was inevitable.

In August 1971, President Richard Nixon finally intervened by suspending the peg dollar had against gold. The Bretton Woods era of a fixed exchange rate system was over. Policy steps were taken to implement a floating exchange rate system, which is the cornerstone of today’s modern forex market. In the 1970s trading desks were established among major banking institutions to facilitate currency transactions for major clients. This private trading arrangement was known as the interbank, a term still used today to describe the electronic trading arrangements among major banks, institutions, and currency dealers. Today prices are determined by the forces of supply and demand within the forex market, allowing traders to capitalize on small swings between the exchange rates of two currencies.

What is Forex?

The currency market, or more specifically the forex market, derives its name from the generic term foreign exchange market. The forex market is a decentralized global network of trading partners, including banks, public and private institutions, retail dealers, speculators, and central banks involved in the business of buying and selling money. The forex market is a spot market, which means that it trades at the current market price as determined by supply and demand within the marketplace. This differs from currency futures traded on the commodity exchange in the United States,which trades a contract price for delivery in the future. In the spot market you are trading cash for cash at the current market price.

The forex market is the largest, fastest-growing financial marketplace in the world. Every trading day the forex market handles a transaction volume of nearly $3.2 trillion, according to a survey done by the Triennial Central Bank in 2007. To put that figure in perspective, the average daily volume on the forex market is nearly 20 times larger than on the New York Stock Exchange. The need for foreign exchange is driven by travelers, multinational corporations, and governments. Tourists from the United States need euros for their European vacations; corporations such as Microsoft exchange profits made overseas into U.S. dollars. Governments hold reserve currencies and manipulate the money supply while they implement their monetary policies. The forex market was created to facilitate the sale of currency to customers who intend to take delivery of the currency; however, the vast majority of trading is done by speculators seeking nothing more than profit.