FOREX MARKET FUNDAMENTALS
This section provides general information to investors, especially those new to forex and want to learn more about the forex market.
FOREX CFD TRADING TERMINOLOGY
If you are new to trading, it is helpful to familiarise yourself with basic forex terminology.
COMMON FOREX TRADING STRATEGIES
After understanding the basic forex terminology, you can study some common forex trading strategies. Understanding and mastering these strategies will let you analyse trends more accurately and elevate your forex trading skills.
Forex margin trading: This means opening an account through a forex broker, depositing funds (margin) as a guarantee, and operating at a credit level set with the broker (normally at leverage levels of up to 500:1). Investors can freely buy or sell forex within the limits of their quota, and profits or losses will be credited to or debited from their investment account automatically. This allows retail investors to use relatively small amounts of funds to obtain larger buying power and use forex as a means of risk diversification and an opportunity to profit from exchange-rate movements. Generally, forex margin trading sees investors speculate on the movement of the underlying asset.
What is a contract for difference (CFD)? A CFD is a derivative instrument that lets investors gain potential profits from anticipating the price movements of financial products such as indices, forex, and commodities. A CFD is a contract to pay or receive the difference in price of an underlying asset between the open and close of the transaction. Transacting in CFDs does not involve transfer or ownership of the underlying asset, which enables greater flexibility including lower fees, easy access to international markets, and the use of leverage.
Why does the forex market exist? A foreign exchange market is a place where buyers and sellers can exchange foreign currencies with each other. The main reasons for their existence include currency exchange demands from importing and exporting businesses, demand from overseas investments, multinational corporations hedging against currency risks, and the investment needs of institutions and individuals.
Main participants in the forex market: Investment banks, commercial banks, central banks, mutual and hedge funds, large corporations, institutional traders, and individuals.
Benefits of the forex market: Highly transparent (largest volume, difficult to manipulate), flexible trading hours (almost 24/5 operations, same-day settlement), and low entry barriers. With leverage, transactions can be made with a minimum of a few hundred USD.
Forex trading hours: Forex is an over-the-counter (OTC) market. It has global characteristics, with markets around the world connected by computer networks to form a continuous market that operates nearly 24 hours a day, 5 days a week. (Some products will be suspended briefly before the opening of the Asian market during the day.) Every week, Wellington in New Zealand is the first market to open and trading ends for the week following the close in Chicago. Since forex trading is conducted through a global network, the exchange of currencies does not rely on a particular forex trading venue. As long as any forex market is open, all currencies can be traded.
Forex market trading scale: According to data from the Bank for International Settlements (BIS), daily average forex trading volume exceeds USD 6 trillion worldwide, making it the biggest financial market in the world. Its scale far exceeds the market for securities and bonds. This makes the forex market extremely fair and transparent.
Forex trading hours selection: Generally, local currencies will be most actively traded during the hours in which their local markets are open. For example, when the American forex market opens, transactions in USD and CAD are generally quite active; when the European forex market opens, EUR and GBP transactions will be more active, and when the Asian forex market opens, AUD and JPY transactions will be more active.
Currency code: Foreign exchange markets use the international standard ISO-4217 codes to stand for currencies. All currencies are represented by three capital letters, with the first two letters generally representing the region or country while the third represents the currency unit. For example, the code for US dollars is USD and the code for Japanese yen is JPY.
Most liquid currencies: According to 2016 data from the BIS, the top seven currencies with the highest average daily trade volume are USD, EUR, JPY, GBP, AUD, CAD, and CHF.
Essential traits of a successful forex trader: Skills in fundamental and technical analysis, sound risk management, excellent trading psychology, and gradually accumulated trading experience.
How to profit from CFD trades: After analysing trends in the price of the product, investors can choose to long or short the price. If the investor is long and the price rises, or if they are short and the price falls, they can close the transaction at a profit.
CFD: Contract for difference. Investors trade a derivative that tracks the price of a particular product without making a transaction in the underlying asset. In theory, anything with a floating price can be traded. Products available to trade with Prospero include major stock indices, forex CFDs, precious metals, and commodities.
Spread: The difference between the buying and selling price for a product on the platform. This is also the main transaction fee for forex traders. The greater the spread, the higher the costs.
Lot: A lot is the standard unit of transaction in the forex market. A standard lot is a transaction size of USD 100,000, a mini lot (0.1) is USD 10,000, and a micro lot (0.01) is USD 1,000. The more lots traded, the greater are the risk and returns. It is important to choose a transaction scale that is appropriate for the size of your account and your risk tolerance.
Price interest point (pip): Abbreviated as pip, the price interest point or percentage in point is the unit of measurement for the change in a foreign exchange rate. One pip is 0.0001 (four decimal places). For example, if the AUDUSD exchange rate rises from 0.7015 to 0.7019, it has risen by 4 pips. In recent years, the average daily movement in AUDUSD is 50–60 pips.
Pip value: The change in profit or loss on a position generated by a movement of one pip in an exchange rate. The formula for calculating the value of a pip is: Pip value = lot size × lots traded × pip size. The result is expressed in the quote currency (the second symbol in the currency pair). For example, when trading 1 standard lot of AUDUSD currency pair, the change in profit and loss brought by every 1 pip change is AUD 100,000 × 1 × 0.0001 = USD 10. This implies that if the AUDUSD exchange rate changes by 50 points in a day, the trading risk on the day is USD 500 per lot.
Open a position: Creating a new position by buying or short selling an instrument.
Close a position: Exiting an established position by selling an instrument or buying to cover a short sale.
Sell (aka short sell): If you expect an exchange rate will fall, you can sell, or “short”, the exchange rate. For example, if people think the value of EUR will fall in comparison to USD, investors can short the EURUSD exchange rate, selling EUR and buying USD.
Leverage: Leverage lets investors gain greater exposure to the market than the value of the cash in their account. Using leverage magnifies the potential profits and risks. Price movements for products in the forex market are relatively low: the average daily movement for major forex products has not exceeded 1% in recent years. Leveraged trading can magnify the investor’s return on their principal. Currently, the default leverage ratio used by mainstream forex brokers is between 100:1 and 500:1.
Margin: Margin is the funds in the trader’s account used as a deposit when making a leveraged transaction. It is not the transaction fees. When a trader opens a trade, the corresponding amount of margin will be allocated according to the leverage ratio set by the broker. Margin could also be described as the minimum cash requirement for opening the trade. For example, if an investor wants to buy 1 lot of AUDUSD at a leverage ratio of 200:1, the margin for the transaction is 100,000/200 = AUD 500. In other words, if a trader wants to trade 1 standard lot, there must be at least AUD 500 in their account.
Available margin: Funds not yet used as margin on open transactions are counted as available margin and can be used to support trading losses and risks, as well as opening other positions. The greater the proportion of available margin to total margin, the safer the account. Available margin = account balance – used margin +/– floating profit or loss on open positions.
Margin call: A request to deposit extra funds if available margin falls below a certain level. Margin trading requires sufficient capital to maintain open positions. If price movements on open positions would result in a loss if the position were closed (a floating loss), that loss is deducted from the available margin, which can risk there being insufficient balance in the account to maintain the positions. Brokers will then issue a margin call to give investors notice that they must fill the gap. If funds are not deposited in time, the broker will close open positions until available margin is positive, realising floating losses and profits.
Actual trading leverage: The default margin leverage level is the same for every investor. The level of risk in the trade will depend on the actual trading leverage. Actual trading leverage = actual transaction amount / account principal
Position: The amount of a trading instrument or currency that an entity owns (e.g., 10 lots, 100 shares, 1 futures contract). Positions can be long (owned and then sold), or short (borrowed and then sold).
Overnight fees or swap:The base interest rates of the two currencies in a currency pair are often different. Therefore, there is a spread between those interest rates. Investors can earn daily interest from a forex transaction or may be required to pay interest daily, depending on the direction of the transaction. When buying high-interest currencies and selling low-interest currencies, an investor can earn interest. Conversely, when buying low-interest currencies and selling high-interest currencies, an investor will have to pay interest.
Currency pair: In a currency pair, the first is called the base currency, and the second is called the quote currency. For example, in EURUSD, EUR is the base currency and USD is the quote currency.
Direct quote: All direct quotes are based on USD, for example EURUSD, USDJPY, GBPUSD, AUDUSD, USDCAD, USDCHF, and NZDUSD.
Cross currencies: Any currency pair that does not include USD, such as EURGBP, AUDJPY, AUDNZD, and CADJPY.
Locked position: Normally refers to the investor opening a new position opposite an original position when the market shows trends against the original position. This is also referred to as a lock or order lock.
Stop-loss: A setting to close a trade at a certain price or a certain level of loss, to prevent greater losses. For a long (buy) trade, the stop-loss price must be lower than the current sell price. For a short (sell) trade, the stop-loss position should be higher than the current sell price.
Take-profit: A setting designed to take profit when the trade objective is reached, before the market moves in the opposite direction. For a long (buy) trade, the take-profit price must be higher than the current sell price. For a short (sell) trade, the take-profit price should be higher than the current buy price.
Limit order: An order to buy or sell at a certain price or better. A limit buy order will be executed when the instrument can be bought at the limit price or lower. A limit sell order will be executed when the instrument can be sold at the limit price or higher. Because they are only executed at the limit price or better, limit orders prevent slippage, in contrast to market orders.
Stop order: An order to buy or sell an instrument after the price reaches a certain level. A stop buy order triggers if the price reaches or exceeds the stop price. A stop sell order triggers if the price reaches or goes below the stop price. Investors making a stop order expect the price will continue to move in the direction of the trade after the stock price is reached. Stop orders are usually market orders, and are subject to slippage.
Slippage: A situation where the market price moves before a transaction can be executed – for reasons including sharp price movements, network delays, and insufficient market liquidity – and the order is executed at a different, often less favourable, price.
Fundamental analysis: A method of analysis that generates expectations of trends in exchange rates by examining social, economic, and political factors affecting supply and demand.
Technical analysis: A method of analysis that looks for trends and other patterns in historical prices, using charts of mathematical formulas, to make predictions about how the market will move in the future.
Swing trading: In swing trading, traders act based on currency price movements in the forex market and look for resulting inflection points. This is one of the most popular methods for trading forex. Changes in foreign exchange rates create fluctuating patterns of different magnitudes, perhaps moving in a single direction or oscillating within a certain range. Traders make profits by looking for the points where prices swing from one direction to another, and by staying in a trade until a profit objective is reached or the short-term trend looks likely to turn again. Swing trades may last for a few days to a few weeks. This kind of trading mainly uses technical analysis, but also requires some understanding of fundamental analysis. On the fundamental side, traders pay attention to releases of influential economic data, seizing the opportunity these present in the fluctuating market.
Trend trading: A trend refers to the direction of price movement in a certain period. When the price change is significant on a technical basis, and fundamental factors confirm the trend on a graph, traders will buy or sell in the direction of the trend and stay in the trade as long as that trend continues. Trend trading normally applies technical analysis to aid decision-making, such as drawing trend lines to describe the trend and charting moving averages to confirm the trend and generate buy and sell signals.
Range trading: When a price oscillates between a resistance line and support line without an obvious directional trend, you can apply the range trading method to buy near the low point of the range and sell near the high point. Range trading is the opposite of trend trading and is a part of swing trading.
Breakout trading: After a period of oscillation in the exchange rate, a “breakout” may occur above or below key levels of resistance and support, which could signal the beginning of a new trend. Breakout trading methods find investment opportunities at breakout points in support and resistance levels, and can be implemented using stop orders. This is one of the most fundamental trading strategies in forex trading.
News trading: Major countries will regularly release important statistics about the economy and monetary policy. Besides these, many other events will occur and be reported that have significant effects on market fundamentals. At these times, financial instruments can experience large price movements. Being able to accurately interpret information and predict trends can allow investors to gain relatively large profits in a short time. News trading requires some experience and judgement to decide what effect particular announcements may have on prices.
Pyramid trading: A strategy involving buying or selling at a certain price, then adding smaller positions in the same direction after achieving a certain level of profit. As the price continues to move favourably, smaller and smaller positions can be added. This magnifies potential gains while limiting losses on newer positions if the price begins to move against the trade.
Martingale strategy: The martingale strategy is a money-management system used in gambling that has become increasingly popular since the 1800s. Using this method, after a losing trade or bet, the trade or bet size is doubled until the next win, which will make back the previous losses. Then, the bet or trade size returns to its starting point. In forex trading, investors can add to losing positions at intervals with double the previous trade size, in the hope of recouping losses and turning a profit when the price turns around, perhaps in the direction of the trend.
Golden cross and death cross trading: Using indicators such as moving averages, MACD, and KDJ, the trader enters a trade when one line crosses above or below another. Specifically, a golden cross occurs when the 50-day moving average crosses above the 200-day moving average, and a death cross occurs when the 50-day average crosses below the 200-day. A golden cross is a bullish (positive) signal and may trigger a buy transaction, while a death cross is a bearish (negative) signal that may trigger a sell transaction. Signals can also be generated using moving averages of different lengths and timeframes, or crosses of other indicator lines above or below each other, or above or below significant levels.