Forex Trading Basics: Supply & Demand Fundamentals
The objective of currency trading is to exchange one currency for another with the expectation that the market rate or price will change such that the currency pair you have bought has appreciated in value relative to the currency you have sold.
If the currency you have bought appreciates in value and you close your open position by selling this currency, or effectively buying the currency that you originally sold, then you are locking in a profit. If the currency depreciates in value and you close your open position by selling this currency, or effectively buying the currency you have sold, then you are realizing a loss.
Cardinal Rule: All trades result in the buying of one currency and the selling of another, simultaneously.
Basic Entry & Exit Rules:
1) Buying a currency is equivalent with taking a long position in that currency.
2) Selling a currency is equivalent with selling short that currency.
OPEN TRADE: An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or lose from fluctuations in the price of that currency pair.
CURRENY SPREAD & DEALING RATES:
A currency exchange rate is always quoted for a currency pair. For example, EUR/USD refers to two currencies: the Euro Dollar and the US Dollar.
EXCHANGE RATE: An exchange rate is simply the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.
A currency exchange rate is typically given as a bid price and an ask price. The bid price is always lower than the ask price. The bid price represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency. The following EUR/USD price quote is an example of bid/ask notation:
EUR/USD: .9726 / .9731
The first component (before the slash) refers to the BID price (what you obtain in USD when you sell EUR). In this example, the BID price is .9726. The second component (after the slash) is used to obtain the ASK price (what you have to pay in EUR if you buy USD). In this example, the ASK price is .9731.
SPREAD: The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .05 or 5 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 2nd decimal place (i.e. USD/JPY may be quoted at 119.45/50), in which case 5 pips represents a difference of .05. Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the inter-bank market.
DIRECT RATES: Most currencies are traded directly against the US Dollar. The market rates that are expressed for such currency pairs are called direct rates. In most cases, the US Dollar is the base currency pair whereby the quote currency is expressed as a certain number of units per 1 US Dollar. For example, the following rate USD/CAD=1.4500 indicates that 1 USD (US Dollars)= 1.4500 CAD (Canadian Dollars).
INDIRECT RATES: For some currency pairs, the US Dollar is not the base currency but the counter or quote currency. The market rates that are expressed for such currency pairs are called indirect rates. This is the case with GBP (British Pound or “Cable”), NZD (New Zealand Dollar), EUR (Eurodollar), and AUD (Australian Dollar). For example, the following rate GBP/USD=1.5800 indicates that 1 GBP (British Pound)= 1.5800 USD (US Dollars).
CROSS RATES: When one currency is traded against any currency other than the USD, the market rate for this currency pair is called a cross rate. Cross rate is the exchange rate between two currencies not involving the US Dollar. Although the US dollar rates do not appear in the final cross rate, they are usually used in the calculation and so must be known. Trading between two non-US Dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-US Dollar currency. There are a few non-US Dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.
BASE CURRENCY: The base currency for the following currency pairs is the Euro (EUR): EUR/GBP, EUR/JPG, EUR/CHF, EUR/CAD. The base currency used when GBP is traded against the JPY (Japanese Yen) is GBP, hence the quotation GBP/JPY.
Spot Deal / Market
A spot deal consists of a bilateral contract between a party delivering a specified amount of a given currency to a counter party and receiving a specified amount of another currency in return, based on an agreed upon exchange rate. Delivery for spot deals occurs within two business days of the deal date, which is referred to as the settlement date. (The settlement date for USD/CAD is one business day after the deal date.)
Market Orders:
Market orders are orders that are executed immediately at the market rate.
Limit Orders:
Limit orders are orders that a trade should be executed (in the future) when certain market conditions occur. There are three types of limit orders:
1) New Positions:
Limit orders: specify that a currency pair should be traded when it reaches a certain exchange rate. Applied when entering into a trade or position, limit orders do not offset a current position.
2) Current / Open Positions:
Take-Profit orders: are used to clear a position by buying (or selling) the currency pair of the position when the exchange rate reaches a specified level. Take- Profit orders are typically used to lock in a profit. For instance, if you are long USD/JPY at 117.42 and believe the price will continue to rise until it reaches 120.00 but are unsure what it will do past 120.00, placing a take-profit at 120.00 will automatically close your position allowing you to lock in your profit.
Stop-Loss orders: are used to clear a position by buying (or selling) the currency pair of the position when the exchange rate reaches a specified level. Stop-Loss orders are typically used to limit any losses that might occur. For instance, it you are long USD/JPY at 117.42 and set a stop-loss at 117.32, your position will automatically be closed at 117.32 and you will be protected from a further price decline. Stop-Loss orders are particularly beneficial because they allow you insurance comfort when leaving a position open while you are no longer actively following the markets allowing you to do other things than watch your computer monitor all day or night.
Now let’s put this terms we can all understand and absorb. Suppose you turn on the television or read the newspaper and you read or see that there is some political unrest in Japan due to the lack of strong leadership in that country. If you believe that the Yen will depreciate as a result of this turmoil, you will have the following bias:
You will be analyzing your real time charts with the bias that you are looking for and uptrend in the USD and a downtrend in the JPY. Therefore you will be bullish the US Dollar and Bearish the Japanese Yen.
Remember this is just added sentiment to help you put the trading odds in your favor. We do not believe in basing all of our entry and exit decisions on purely Fundamental analysis. After all, the charts do not lie and any instability or negative reaction to a specific currency will be shown on the chart thru price and volume.
Martin Chandra (forex-trading-tutorial.com) is a full-time investor. He has been researching investment strategies and make his own living. Learn more at forex-trading-tutorial.com
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