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A Foreign Exchange (FOREX) Trading Primer

The largest traded “market” in the world is not the U.S., Japanese or European stock markets. It’s the foreign exchange market. It’s called Forex for short, or also called the cash currency market. Speculators can and do trade this huge market, in which nearly 2 trillion dollars (and other currencies) can change hands every day.

The main function of the foreign exchange market is to provide the mechanism for making cross-border payments and determining exchange rates between currencies. Major components that make up the Forex market are the spot market (37%) used by traders and speculators, swaps (43%), and options and forwards (20%).

A Forex trade is executed through the simultaneous buying of one currency and selling another (currency pair). While most currencies are tradable, five currencies (four currency pairs) represent the majority of foreign exchange trading volume. They are the Euro ( EUR/USD), Yen (USD/JPY), British pound or cable (GBP/USD), and Swiss franc (USD/CHF).

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Figure 1 – Chart showing breakdown of currency pairs traded on Forex markets. Source: Triennial Central Bank Survey 2004 and 4xPairs.com.

A major difference between Forex and other financial markets is that the former is open 24 hours a day. The trading day begins in Sydney, Australia on Monday while it is still Sunday in North America and Europe, and ends in New York on Friday afternoon.

There are no commissions in Forex trading–only point spreads measured in pips, with one pip being equal to one-tenth of one percent (0.01%). Since the point spread in pips represents the cost of entry, it is desirable to keep it to a minimum and why major currency pairs are most popular. The majors experience the tightest spreads, often as low as three to four pips.

Spot currency trading lots typically are worth $5 million to $10 million, with the minimum contract size being $500,000. Amounts smaller may be traded with some firms offering minimum investments of as little as a few hundred dollars on margin far exceeding 100:1. However, this is extremely risky and therefore not recommended. Currency futures and options contracts may also be traded for much smaller amounts, but firms handling the trades generally charge commissions.

FOREX Trading Becoming Ever More Popular
Of all financial instruments traded, Forex is believed by many traders to be the best suited for technical analysis, for a number of reasons. First, it dwarfs all other markets by trading volume. According to an April 2004 Triennial survey for the Bank for International Settlements, average daily turnover in traditional foreign exchange markets (Forex) amounted to $1.9 trillion in the cash exchange market and another $1.2 trillion per day in the over-the-counter (OTC) foreign exchange and interest rate derivatives market.

Forex trading has grown some 2000% over the last three decades, rising from barely $1 billion per day in 1974 to an estimated $2 trillion by 2005. Markets never close so there is no build-up or backlog of client overnight orders or pent-up reaction to news stories hitting the market at the open. This means that there are no gaps to create instant losses (or gains) for those holding overnight.

The Trend is Indeed Your Friend
There are two basic types of markets: trending and trading-range markets. It is far easier to make money in the trending markets. Currencies tend to experience longer-lasting trends than other markets, and can last for months or even years. This makes them ideal vehicles for trend-trading and breakout systems. This explains why chart pattern analysis works so well in Forex trading. With such widespread groups playing the game around the world, crowd behaviour plays a large part in currency moves, and it is this crowd behaviour that is the foundation for the myriad of technical analysis tools and techniques.

Lower Volatility in FOREX Trading
Due in part to its size, Forex is less volatile than other markets. Lower volatility equals lower risk. For example, the S&P 500 Index trading range is between 4% and 5% daily, while the daily volatility range in the Euro is around 1%.

The Intermarket Advantage
One example is the “Intermarket” method of market analysis developed many years ago by respected industry professional Louis B. Mendelsohn. Trading veterans know that markets are interdependent, with some markets more heavily influenced by certain markets than others. Mendelsohn’s VantagePoint analytical software detects hidden, yet repeating patterns that occur between related markets.

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Figure 2 – Shows other markets that drive and influence the Euro/USD. Source: Trade4xMarkets.com

The challenge from a trader’s perspective is how to take these often-complex relationships and integrate them into a workable trading strategy. For the purposes of this article, VantagePoint Intermarket Analysis Software charts developed by Market Technologies (tradertech.com) were employed. It uses a combination of neural network indicators to incorporate intermarket forces analysis into the software. Indicators provide forecasts of a potential change in market direction in advance, thanks to an ability to analyze a complex array of intermarket forces acting on the issue under study.

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Figure 3 – Shows VantagePoint Intermarket Analysis software forecasting trends in the AUD/JPY market with nearly 80% accuracy. Source: VantagePoint Intermarket Analysis Software – VP4x.com

Don’t Forget Market Fundamentals
Like their commodity and stock counterparts, successful Forex traders also can’t forget about the fundamentals of the market. Here are some reports worth discussing.

  1. Interest rate announcements by central banks. Language in meeting minutes published following announcements or rate change decisions. E.g. Federal Open Market Committee (FOMC) Minutes.
  2. Government debt and deficit figures that show changes for the better, or worse. Increasing deficits, for example, often portend an increase in interest rates as the government competes with the private sector for investment capital. The difference between stocks and Forex is that increasing rates are usually good news for a currency.
  3. Quarterly GDP reports. Preliminary national GDP announcements also have the potential to affect market sentiment.
  4. Economic or geopolitical events such as elections, conflicts and political uprising etc. Anything that investors or traders think may destabilize or impact the market.
  5. Reports such as the Institute of Supply Management in the US and Purchasing Management Index in Europe tend to be closely watched by traders.
  6. Industrial production figures, jobs (non-farm payrolls in the U.S.) and employment figures can impact markets including currencies since they could have a direct bearing on national interest rate and economic policy.
  7. Yen traders closely follow Japanese reports such as the Tankan quarterly survey for insights into currency movement.
  8. Market sentiment published by market commentators and news services. It is often a good idea to buy on rumour, sell on news.

Forex is the ideal market for the experienced trader who has paid his or her “trading tuition” in other markets. Forex is by far the largest market in dollar volume, is less volatile, experiences longer, more accentuated price trends and does not have trading commissions.

However, there are no free lunches. Traders must use all the trading tools at their disposal. The better these fundamental and technical tools, the greater their chance for trading success. While intermarket and other relationships are often complex and difficult to apply effectively, with a little high-tech help, traders and investors can enjoy the benefits of using them without having to scrap their existing trading methods.

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