Lesson 2: Currency Trading Basic Concepts

Lesson 2: Currency Trading Basic Concepts

  • Introduction
  • The Very Basics
  • Quotes
  • Lots, Pips and Spreads
  • Margin (Leverage)
  • Rollover
  • Type of Orders
  • Summary Report

Introduction

It is important to clearly understand how the Forex market works. In this lesson we will review all basic concepts about trading in the Forex market and you will learn, inside-out at what price point we buy and sell, how leverage works, when do you pay interest, how currency pairs are commonly quoted and much more.

This lesson is structured in the following way:

Section II: The Very Basics – Basic stuff about the Forex market.

Section III: Direct/Indirect and Base/Counter Currency Pairs – Have you ever wondered why the USD is sometimes the first quoted currency and why sometimes it is the second?

Section IV: Lots, Pips and Spreads – An easy way to calculate the pip value for every currency pair, why currencies have a spread and what is it there for as well as different trading sizes available for traders.

Section V: Margin (Leverage) – This is one of the most important advantages of the forex market, you can’t afford not to know how it works.

Section VI: Rollover – Planning on taking trades for the long term? Read this section, you will learn which currency pair’s pay you interest on a daily basis (while your trade is open).

Section VII: Type of Orders – A must for all traders, different strategies require different ways to enter the market; here you will learn which type of order its better for different trading styles.

The Very Basics

ISO Codes

Currencies, as stocks, are not referred by their full name; they are standardized for easier reference.
The International Standardization Organization (ISO) developed what is called ISO Codes for Currencies. The ISO currency codes are made of three letters:

• The first two letters represent the abbreviation of the country of each currency, and,
• The last one represents the first letter of the country’s currency (dollar, franc, etc.)

Currencies can also be called by their nickname.

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* CHF, CH stands for Confederatio Helvetica, the Latin translation. This avoids choosing one of the four official languages in Switzerland.

The seven major currencies
Form all the transactions involved (volume) in the Forex market, 85% is produced by the seven majors (see table below).

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*Since 2 currencies are involved in each transaction it totals 200%

Currency Pairs as Instruments

It is easier to consider currency pairs as main instruments. For instance, you are expecting the EUR to appreciate; you go long EUR (EUR/USD). What you are doing here is buying the EUR and selling the USD. But it is not practical to view it that way. It is easier to consider the EUR as the main instrument, so that you will only say “I am long Euro”.

On the other side, if you are expecting the dollar to appreciate. You will go short EUR (EUR/USD) here you are selling the EUR and buying the USD. You would say here, “I am short EUR”.

Direct and Indirect Quotes

Every local currency can be quoted directly or indirectly against other currencies (most of the time the US Dollar):

Direct quotation: Amount of local currency that is needed to buy one unit of the foreign currency (most commonly the USD)
And,

Indirect Quotation: Amount of local currency that is to be received when one unit of the foreign currency is sold.

Ok, now imagine your local currency is the EUR, in this case the quotation scheme against the US Dollar would be:

Direct Quotation: USD/EUR – How many Euros to get one US Dollar
And,
Indirect Quotation: EUR/USD – How many US Dollars to get one Euro

For the sake of simplicity, sometimes the US Dollar is called the “Foreign Currency”, so for the majors we have the following:

Direct Currencies
– USD/JPY
– USD/CAD
– USD/CHF

Indirect Currencies
– EUR/USD
– GBP/USD
– AUD/USD

Counter and base (or quote) currency

The first currency of the pair is always called base currency.
The second currency is called counter currency (or quote currency).
Currency pair quotes are always expressed in units of the counter currency to get one unit of the base currency.

EUR/USD = Base Currency/Counter Currency

This is how many USD are required to get one EUR

If the EUR/USD quote is 1.2520, then it requires 1.2520 USD to get one EUR…and the same goes for other currency pairs:

If the USD/JPY quote is at 110.05, it requires 110.05 JPY to get one USD
TIP: The EUR is always the dominant base currency against all other currencies. All currency pairs against the EUR are identified as EUR/USD, EUR/JPY, EUR/CHF…
The next in the hierarchy is the GBP, which is always the base currency, but against the EUR (EUR/GBP).

Lots, Pips and Spreads

Lot sizes

Transactions can be conducted via standard, mini, micro or variable lot sizes:

Standard lot sizes: The standard lot sizes accounts for a 100,000 units of the base currency.
(The amount of margin required to open a standard lot varies depending on the leveraged (margin) used, we will get to that in a moment).

Mini lot sizes: The mini lot size accounts for 10,000 units of the base currency (ten times smaller than the standard lot size).

Micro lot sizes: The micro lot size accounts for 1,000 units of the base currency (ten times smaller than the mini lot size and a hundred times smaller than the standard lot size).

Variable lot sizes: Some brokers allow you to fix the position size based on your needs as a trader. For instance you could trade a position size of 234,644 or 5,869 units of the base currency.

Let’s see some numbers…
A trader goes long EUR/USD at 1.4530

Standard lots: the trader is buying 100,000 Euros at 145,300 US Dollars
Mini lots: our trader is buying 10,000 Euros at 14,530 US Dollars
Micro lots: our trader is buying 1,000 Euros at 1,453 US Dollars
Variable lots: the trader is buying 234,644 Euros at ??? (See answer below)

Question 1– How many US Dollars our trader used to buy 234,644 Euros when she used variable lots?

Pips

A pip is the minimum incremental move a currency pair can make. Pip stands for “price interest point.” For most currencies a pip is one 10,000th of the rate (1/10,000). The only exception of the seven majors is the USD/JPY (and other currency pairs where the JPY is involved, EUR/JPY, GBP/JPY, etc.) where the value of one pips is one 100th (1/100).

In the EUR/USD a move from 1.2532 to 1.2553 is equivalent to 21 pips while in the USD/JPY a move from 110.05 to 111.10 is equivalent to 105 pips

Calculating pip values

Although most trading platforms calculate the pip value automatically, it is important to know how it is obtained.
In the case of the USD/JPY the calculation is as follows:

In the yen, .01 equals to 1 pip.

USD/JPY rate = 116.87

.01/116.87 = .000086 *

*This result is the value of one pip in a contract size of 1, if we traded standard lots, then .000086 x 100,000 = 8.6 USD per pip.

In the case of the EUR/USD the calculation is as follows:
In the Euro, .0001 equals to 1 pip.
EUR/USD rate = 1.2316
.0001/1.2316 = .000081*
*This is the value per pip if we traded a contract size of 1.

NOTE: This is the pip value in Euros, (always in terms of the base currency). To convert it to USD we need to add one more step:

.000081 times the exchange rate. This would be:
.000081 x 1.2316 = .000099 rounds to .0001* (as we left out some decimals in our prior calculation).
*Again, this is the value for a contract size of 1, if we traded mini lots, then .0001 x 10,000 = 1 USD per pip. (For standard lots it would be 10 USD per pip).

Hey, did you notice we first divided .0001/1.2316 = .000081 and then we multiplied the result this way: 0.000081 x 1.2316 = .000099. So, would it be correct to avoid both calculations as they cancel each other? Absolutely, so you only need to multiply the pip value times the contract size to get the value of each pip! Hey, but remember, this is only good for currency pairs where the USD is the counter currency.

HINT: When trading any pair where the USD is the counter currency (direct currency pairs) such as: EUR/USD, GBP/USD, NZD/USD, etc. Each pip always has a value of US$10 for standard lots and US$1 for mini lots.
Question 2 – Just to make sure you understood the mechanics of this correctly, here is a tough one: At what price did we buy USD/JPY to have a pip value of 10 USD per pip?

Bid/Ask spread

Currency prices are quoted with a spread. The spread is the difference between the buy and sell prices (the cost for traders to make a trade)
Bid is the price a dealer (our broker) is prepared to buy at, the trader (we) is to sell at this price.
Ask (or offer) is the price a dealer is prepared to sell at, and the trader (we) is to buy at this price.

Currency prices are commonly quoted in the following way:

EUR/USD 1.2528/31 spread = 3 pips

The bid quote is 1.2528.

Replace the last two digits (31) in the left quote (28) to obtain the ask quote:

The ask quote is 1.2531

For currency pairs and crosses where the JPY is involved it changes a bit:

USD/JPY 116.45/48 spread = 3 pips

Bid: 116.45
Ask: 116.48

Now, spreads can be fixed or variable. Most of the time and under normal market conditions the spreads are fixed (i.e. constant 3 pip spread). But when volatility increases (i.e. when important fundamental announcements are released) the spread can be increased (i.e. going from 3 pip spread to a 15 pip spread).

Ok, now that we understand these three concepts let’s go through a typical trading scenario.

Question 3 – Why do you think different currency pairs and crosses have different spreads, for instance, the EUR/USD usually has a spread of 2-3 pips, while the GBP/JPY is commonly quoted with a 5-7 pip spread? Or exotics currencies such as the USD/MXN which is quoted with a 40 pip spread?

Typical Trading Scenario
The Euro quote is EUR/USD: 1.2315/18
This means that we can buy one euro at 1.2318 USD or sell one euro at 1.2315 USD. But we are not going to buy only one Euro, we need more, let’s buy say 100,000 Euros.

We decide the EUR is undervalued so we go long EUR/USD (buying EUR and selling USD) on one standard lot (100,000 Euros). We bought 100,000 Euros and paid 123,180 USD for them (we used the ask quote).

As we expected, the EUR/USD goes up and we decide to close our position.

The current quote is now quoted at 1.2360/63. Now we need to sell back our 100,000 Euros to realize our profits. We sell 100,000 Euros at 1.2360 (now we use the bid quote) and receive 123,600 US dollars.

We bought at 1.2318 (123,180) and sold back at 1.2360 (123,600). That is a gain of 42 pips and in dollar terms 123,600 – 123,180 = US$420 in profits

Margin (Leverage)

Margin Trading

In contrast to other financial markets where you require the full deposit of the amount traded, in the Forex market you only require a margin deposit. The rest of the amount will be granted by your broker (you will borrow it from your broker).

The leverage could go as high as 400:1 depending on your risk profile and the broker chosen. 400:1 means that you will only need 1/400 in balance to open one position (plus the floating losses). Under this scheme, you only need .25% of the total amount traded.

For example, if you were to trade one standard lot using 400:1 (which equals 100,000 units of the base currency) you would only need $250 ($100,000/400 = $250) for indirect currency pairs
[USD quoted as the base currency].
But be careful, HIGH LEVERAGE CAN LEAD TO SUBSTANTIAL LOSSES AS WELL AS SUBSTANTIAL PROFITS. We will get in to detail later on.

Leverage Comparison

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There are two things to be considered about margin trading:

1 – Margin trading allows us to keep our risk capital at the minimum since a small amount of money is used to conduct a bigger transaction.
2 – The greater the leverage used, the more risk capital you have at risk, and this takes us to the next concept…

Margin Call

A margin call is the traders’ worst enemy. Unfortunately, this happens to too many traders, some because the use of poor money management techniques (or no usage at all) and some others because they are not even aware of it.

A margin call arises when the balance of the account falls below the maintenance margin (capital required to open one position, for example $250 when using 400:1 or $1,000 when using 100:1 on one standard lot). See the above table.

In a margin call your broker sells off (or buys back in the case of short positions) all your trades.

How so? Let’s dig in a little deeper and try to calculate the maintenance margin…

How to calculate the maintenance margin

Again, most brokers calculate this value automatically but it is good to know how this number is calculated.

A trader goes long EUR/USD at 1.2318 on one standard lot.

He is using 100:1 or 1% of margin.

He bought 100,000 Euros at 123,180 USD, so the maintenance margin in USD is 1231.80 USD

(123,180 x 1%).

If this trader had used 200:1 or 0.5%, the margin would be at 615.9 USD (123,180 x 0.5%)

For direct currencies (or currency pairs where the USD is the base currency) this calculation is simpler:

Since the transaction is in USD, we only need to obtain its percentage in the following way:

If we go long USD/CHF on one standard lot at 1.1445, we are using 100:1

We bought 100,000 USD and paid 114,450 CHF for them, so the maintenance margin in USD is

US$1,000 (100,000 x 1%).
Let’s take a concrete example on a margin call:
One trader has opened an account to trade the Forex market. She has made an initial deposit of US$4,000 to her trading account. The next morning she decides to go long EUR (EUR/USD) at 1.2318 on two standard lots (the position equals to US$246,360 = 2 x US$123,180).

She is using 100:1, so the maintenance margin would be US$2,463.6 (US$246,360/100=US$2,463.6).

The next morning, as she wakes up and opens up the charts, dang!!! The EUR has fallen like a rock. When she opens her trading platform, the balance is at US$2,463.60. The adverse price action got her margin called.

When she entered the trade with two standard lots, the maintenance margin raised at US$2,463.60; she only had left the other $1,536 to support her losses. A 100 pip movement on the EUR in two standard lots accounts for US$2,000. That night, the EUR fell 113 pips, and all positions were closed by the broker.
What would have happened if she used different leverage levels?
400:1 – ?
200:1 – ?
100:1 – She got margin called
50:1 – ?
25:1 – ?

This illustrates the perils as well as the advantages of high leverage!

Rollover

The Forex market is traded on a 2-day business value date. A new value date usually happens after 17:00 EST. So the rollover occurs when the settlement of one trade is rolled forward to the next value date (position or transaction is held overnight), with the cost of the interest rate differential between the two currencies.

For instance, if a trader opens one position on Monday and holds it until Tuesday, the value date will be Thursday.

Triple Rollover

However, if one trader opens a position on Wednesday and holds it until Thursday, the value date would of be Saturday, but since there are no markets on Saturday, the position is rolled forward to Monday. Gaining or paying three times the interest rate, this is called triple roll over.

Paying and Gaining Interest

Example on rollover

A trader goes long USD/JPY at 111.50 (two standard lots, position opened before 17:00 EST). The position is closed the next day.

If Interest rates are:

US – 3.5%
Japan – 0.15%

Rollover calculated in USD

US$ 200,000 [(.035-.0015) / 360] = US$18.61

We use US $200,000 because we traded 2 contracts: 100,000 x 2 = 200,000

360 because the interest rate shown is paid over a daily basis. Since our trader only kept the position one day, we have to divide it by 360 (financial transactions are rounded off to 360 days per year).
Rollover calculated in JPY

US$100,000 = 11,150,000 JPY per lot; 11,150,000 x 2 lots = 22,300,000

360 because the interest rate shown is paid over a daily basis. Since our trader only kept the position one day, we have to divide it by 360 (financial transactions are rounded off to 360 days per year).

Interest rates by currency pairs as of November 2007

Type of Orders

Orders

There are several ways in which a trader can get in and out the market. Different approaches (or trading strategies) require different ways to get in and out the market.

Entry Orders

Market order – Is an order to buy or sell a currency pair at the current market price. For instance, if the EUR/USD quote is 1.2538/41, using a market order will get you long at 1.2541 or short at 1.2538.

Limit order – This order allows us to get in the market below the current price (if we intend to go long), or above the market price (if we intend to go short.) This kind of market order is commonly used for a range bound strategy or by retracement traders.

Range-bound strategies: Buy at the bottom and sell at the top of a given price channel.
Retracement strategy: Waiting for a pull back (when trying to get long) or for a rally (when trying to get short) before entering the market.

Stop entry order – A stop entry order gets you in the market above the current price if you are trying to buy, or below the current price if you intent to sell. This kind of order is commonly used by breakout traders.

Breakout strategy: Waiting for the market to reach new highs/lows or break an important level before entering a trade.

Exit Orders
Limit order – A limit order (or take profit order) specifies at what rate you will exit the market to take profits. If a trader is long, the limit order must be above the entry price. If the trader is short, the limit order must be below his/her entry level.

Stop order – A stop order (or stop loss order) specifies the maximum loss you are willing to take on any given trade in terms of pips. If you are long, the stop loss order must be below the entry level; on the other hand, if you are short, the stop loss order must be above the current price.

Duration of Orders

GTC (Good till cancelled)

This order remains active (“good”) until reached (filled) by the market action or cancelled by the trader.
GTN (Good till N, where “N” is a time period such as 1 hour, 1 day, 1 week, etc.)

Some brokers allow you to define how much time an order can be active until cancelled.

This order remains active (“good”) until reached (filled) by the market action or until the end of the defined time period (1 hour, 1 day, etc).
OCO (Order cancels the other)

An OCO order is a combination of two limit and/or stop orders. One order is placed below the market action and the other is place above the market action (doesn’t matter whether they are buy or sell orders), when the market fills one order the other gets cancelled.

Summary Report
Make sure you clearly understood the following before taking the quiz:

– How to calculate the pip value for each currency pair and crosses
– The difference between the bid and ask, where do we buy and where do we sell
– What is margin and how is it calculated
– Why margin can lead to substantial profits, but also substantial losses
– What is rollover, when do we pay and when do we collect interest

Ok, we got a few Questions about this lessons, here are the answers:
Question 1 – In our example where the trader went long EUR/USD at 1.4530 we were asked the amount of USD we used to buy 234,644 Euros (variable lot size). To get to the answer we simply need to do the following calculation:

234,644 x 1.4530 and this equals to 340937.73,
So we bought 234,644 Euros at US$340937.73

Question 2 – In the second brain feeder of this lesson, we were asked at what price we bought USD/JPY so that each pip has a value of 10 USD per pip.

We usually calculate the pip value using two variables: how much is one pip worth in the USD/JPY pair (0.01) and the actual quote (i.e. 116.47), in this case however, we already know the pip value which is US$10 and how much is one pip worth and we need to calculate the quote, so the equation would be:

0.01/X = 0.0001, solving for X we get: 0.01/0.0001 = X, and X = 100

So the answer is: in order to get a pip value of US$10 in the USD/JPY, the USD/JPY quote must be 100.00

Question 3 – In this question we were asked to give a reason why different crosses and currency pairs have different spreads? Wouldn’t it be easier to have the same spreads on all of them?

Because the forex market works just as any other market, remember the example we used on Lesson 1 about the used car markets? Well, the same happens to the Forex market, currency pairs that are traded heavily tend to have the tighter spreads and those that are barely traded have larger spreads. And as a result, those that are heavily traded tend to have smoother moves than those that are barely traded hence, it’s riskier to trade exotics or some crosses than the majors because of their low volume.

Question 4- In the 4th question we have to calculate what would had happened to the trader for different levels of leverage with the following details:

Trading account of US$4,000, she bought 2 standard lots of EUR/USD at 1.2318 and she had an adverse movement of 113 pips (US$1130 per lot).

What would have happened if she used different leverage levels?

400:1 – At this leverage level, the maintenance margin is US$615.9 (246,360 x 0.25%). So there was enough capital to support the adverse movement.

200:1 – At this leverage level, the maintenance margin is US$1231.8 (246,360 x 0.50%). So she had left 2768.2 to support possible losses and guess what, she made it! The adverse movement accounted for US$2260, so there was enough capital to support the adverse movement.

100:1 – We saw this in the material and she got margin called.

50:1 – She is not able to open such trade as the maintenance margin is larger than what she had in her trading account: Maintenance Margin: US$4927.2 vs. US$4,000 in her trading account.

25:1 – She is not able to open such trade as the maintenance margin is larger than what she had in her trading account: Maintenance Margin: US$9854.4 vs. US$4,000 in her trading account.

Wait a minute… Are you saying using higher leverage levels is actually safer than using lower levels of leverage?

No, absolutely not. Higher leverage levels are ALWAYS equivalent to larger risks. Think of it this way, Imagine she had two accounts using 100:1 in one of them and 200:1 in the other. Instead of a 113 pip movement we got a 150 pip movement, so she got margin called on both of them.

In the account she used 200:1 she ended up with US$1,231.8 (the maintenance margin). While in her other account where she used 100:1 she had US$2,463.60 left. So, the larger the leverage used, the more of your “risk capital” is at risk.

Also, yes, margin helps us open larger position with only a fraction of the transaction size and because of the larger transaction size profits are larger, but when the market goes against us, losses are also larger!!!