The Forex Market

by admin on May 15, 2012

The Forex Market

History of the Forex Market

Until the 1970s or so, currency trading was limited mostly to the needs of large companies conducting business in multiple countries.

  • Trading for investment and speculative purposes was not widely practised at this time, and most trading was centered on commodities and individual stocks.

The Bretton Woods Accord – Courting Controversy

  • After World War II, economies in Europe were left in tatters.
  • To help these economies recover – and to avoid mistakes made in the wake of the First World War – the Bretton Woods Accord was convened in July 1944.
  • Several resolutions arose from Bretton Woods, but it was the “pegging” of foreign currencies to the U.S. dollar that arguably had the greatest immediate impact on the global economy.

Gold Standard Currency – A commitment to fix the value of a currency to a specific quantity of gold. Under this system, the holder of the country’s currency can convert funds to an equal amount of gold.

Fiat or Floating Currency – Fiat currency is the opposite of a gold standard arrangement. In a fiat currency system, the currency’s value rises and falls on the market in response to demand and supply pressures. It is this fluctuation that makes it possible to speculate on future currency values.

Pegging U.S. Currencies to the U.S. Dollar

  • By pegging (or linking) these currencies directly to the dollar, the value of the pegged currencies remained dependent on the value of the dollar.
  • At the same time, the value of the dollar was tied to the price of gold which, at the time of the Bretton Woods Accord, was valued at $35 an ounce.
  • The U.S government was obligated to maintain gold reserves equal to the amount of currency in circulation, making the United States a true gold standard economy.

Evolution of an Open Forex Market

Why We Have Richard Nixon to Thank

  • It did not take long for cracks to appear in the Bretton Woods Accord.
  • For the pegged currencies, it was impossible for individual countries to manage the value of their own currency.
  • Likewise, the value of the dollar itself was subject to fluctuations in the price of gold.
  • As resistance grew to the restrictions imposed by the original agreement, two events in particular would spell the end of the Bretton Woods Agreement.

hedge is the practice of buying a physical commodity to protect against a possible currency devaluation.

The Bretton Woods Accord was not popular with every country included in the agreement. By linking many European economies to the U.S. dollar, the dollar became the de facto world currency. This made it impossible for sovereign nations to manage the value of their own currency. Some U.S. officials were likewise unhappy with tying the U.S. dollar to the price of gold. With this arrangement, a run-up in gold prices also forced the value of the dollar upwards, and this contributed to the inflation crisis of the early 1970s.

1. The Eurodollar Market

  • The first attack on Bretton Woods came in the form of what would be known as the Eurodollar market.
  • The term “eurodollar”, defines any instance of U.S. dollars deposited in a bank outside the United States – initially, the source of much of the foreign-held dollars was oil.
  • The Soviet Union became an important oil producer shortly after World War II, and because oil contracts sold on the international markets were settled in U.S. dollars, the Soviet Union started receiving huge amounts of U.S. currency.
  • Coincidently, this period also marked the beginning of the “Cold War” between the east and the west.
  • Worried that their bank accounts could be seized by the U.S., the Soviet Union opted to deposit its U.S. dollars in European banks, out of the reach of American authorities.
  • As the number of U.S. dollars held in this new eurodollar market grew, it soon became an important source of lending capital for governments and large companies around the world.

Market-Maker – A dealer or broker that provides a two-way quote (i.e. a bid and ask price) for which the dealer agrees to buy or sell. Offering both sides of a trade literally “makes” a market for those wishing to engage in currency trading.

2. U.S. Inflation and the Energy Crisis

  • In 1971, inflation in the U.S. continued to erode the purchasing power of the dollar. At the same time, an energy crisis was simultaneously pushing up the price of oil and other commodities.
  • As a result, investors – as is often the case when confusion reigns in the markets – turned to gold as a hedge to protect savings.
  • The increased demand caused gold prices to soar and because the dollar was tied to gold, the U.S. dollar followed suit, further exacerbating the inflationary pressures.
  • Finally, in an attempt to deal with surging inflation in the U.S. economy, President Nixon dropped the gold standard requirement and devalued the U.S. dollar to 1/35th of an ounce of gold.
  • This effectively ended not only the gold standard, but also the Bretton Woods-imposed pegging of currencies, leading ultimately to free-floating individual currencies based on market conditions and other economic factors.

The Interbank Market and OTC Trading

  • Sometimes referred to as institutional forex trading, the Interbank market consists of a small group of large banks. Non-bank outsiders are forced to pay high service fees to trade in this market.
  • Forex trading is an “over-the-counter” (OTC) market, and is not conducted in a physical location such as a stock exchange.
  • A forex deal exists as a contract between two parties.

Exchange-Based Trading

  • The Chicago Mercantile Exchange (CME) became the first exchange to offer currency trading.
  • In 1971, the CME launched the International Monetary Market (IMM).

The Rise of Web-Based Trading and Forex Market-Makers

  • In recent years, new developments in web-related technologies have made it possible for a number of independent brokers to develop internet-based trading platforms.
  • These brokers serve as market-makers and provide a two-way quote for each currency pair they support.

Benefits of Forex Trading & Market Participants

 Some form of currency trading has been conducted for the past three hundred years or more. But with the growth of a vibrant over-the-counter (OTC) market, forex trading has become available to a much wider audience and is no longer reserved for wealthy individuals and large corporations. The growing number of active forex traders – combined with the inherent advantages of forex trading as discussed in this chapter – have helped propel the currency market to a multi-trillion-dollar-a-day operation serving the needs of a wide range of participants.

Market Liquidity and Volatility

  • The forex market is the largest and most liquid of the financial markets.
  • Daily activity often exceeds $4 trillion USD a day, with over $1.5 trillion of that conducted in the form of spot trading.
  • Forex spot trades consist of a contract to trade a given amount of a currency pair with a market-maker, at the advertised buy / sell price (the spot rate).
  • It is the existence of volatility within the forex market that enables trader’s to take advantage of exchange rate fluctuations for speculative purposes.
  • Traders must be aware that greater volatility also means greater risk potential.

Liquidity – Refers to the number of buyers and sellers in the market willing to trade at any given time. Generally speaking, the greater the liquidity within a market, the greater the number of trades completed, which translates into higher volumes.

NASDAQ and NYSE dollar value based on 2009 data
Foreign Exchange dollar value estimates from the Bank for International Settlement (BIS), 2010

Market Hours and Liquidity

  • Forex trading operates 24 hours a day, five days a week. The greatest liquidity occurs when operational hours in multiple time zones overlap.
  • It is important to understand the correlation between liquidity and market activity.

Low Cost of Forex Trading

  • The cost to trade with most forex brokers is the spread. This is the difference between the bid and the ask price.
  • Spreads in the forex market also tend to be much less (or tighter) than the spreads applied to other securities such as stocks. This makes OTC forex trading one of the most cost-effective means of investment trading.

Advantages of Margin-Based Trading

  • Most OTC forex brokers offer margin-based trading accounts.
  • Margin-based accounts differ from credit-based accounts in that when trading in a margin account, you must first open an account with your broker, and thenfund the account by depositing money into the account.
  • Once you have funded a margin account with your broker, you can engage in any trading activity you wish so long as you have sufficient margin remaining in your account.
  • Leverage makes it possible for you to trade larger positions than would otherwise be possible based on your actual account balance.
  • This means that leverage can provide greater potential for returns.
  • The downside of course is that there is also greater potential to lose money and you can incur significant losses in your account very quickly.

Don’t worry if some of these terms such as spread or margin are new to you. We will be covering all this in greater detail in Lesson 3 – Currency Trading Conventions – What You Need to Know Before Trading.

Profit Regardless of Market Direction

  • A short-sale – or simply a short – is the selling of a currency pair before you buy it.
  • It is very easy to enter into a short-sale when trading in the forex market.
  • In order to make a profit on a short, you must buy the currency back for lessthan you received when you sold it. The difference represents your profit or loss.
  • The ability to engage in short-selling means that it is possible for you to profit no matter which way the market is trending.
  • When rates are increasing, you can earn a profit if you buy (go long) a currency pair, and then sell it later for more than you paid.
  • When rates are falling, you can earn a profit if you sell (go short) a currency pair, and then buy it later for less than you earned when you originally shorted the currency pair.

Understanding Leverage – What You Don’t Know Can Hurt You

Leverage Ratio and Minimum Margin Requirements

  • Leverage is expressed as a ratio and is based on the margin requirements imposed by your broker.
  • For example, if your broker requires you to maintain a minimum 2% margin in your account, this means that you must have at least 2% of the total value of an intended trade available as cash in your account, before you can proceed with the order.
  • Expressed as a ratio, 2% margin is equivalent to a 50:1 leverage ratio (1 divided by 50 = 0.02 or 2%). The following table shows the relationship between leverages and minimum margin requirements:Comparison of leverage ratios and the minimum margin requirements expressed as a percentage.
  • If Leverage Ratio is… Then, the Minimum Required Margin equals…
    50:1 2%
    40:1 2.5%
    30:1 3.3%
    20:1 5%
    10:1 10%
    • As a trader, it is important to understand both the benefits, and the pitfalls, of trading with leverage.
    • Using a ratio of 50:1 as an example, means that it is possible to enter into a trade for up to 50 dollars for every dollar in the account.
    • This is where margin-based trading can be a powerful tool – with as little as $1,000 of margin available in your account, you can trade up to $50,000 at 50:1 leverage.
    • This means that while only committing $1,000 to the trade, you have the potential to earn profits on the equivalent of a $50,000 trade.
    • Of course, in addition to the earning potential of $50,000, you also face the risk of losing funds based on a $50,000 trade, and these losses can add up very quickly.
    • Traders suffering a loss without sufficient margin remaining in their account run the risk of triggering a margin call.
    Unlike some brokers who allow excessive leverage ratios of 100:1 or even more, OANDA caps leverage at a maximum of 50:1 for all traders. As a new trader, you should consider limiting your leverage even further to a maximum of 20:1, or even 10:1. Trading with too high a leverage ratio is one of the most common errors committed by new forex traders. Therefore, until you become more experienced, OANDA strongly urges you to trade with a lower ratio.

    The profit or loss for a trade is notrealized until the trade is closed. An open trade or position is said to beunrealized.

    Margin Calls

    • When trading on leverage, you are in effect “borrowing” money from your broker. The funds in your account (the minimum margin) actually serve as your collateral.
    • Therefore, it is only natural that your broker will not allow your account balance to fall below the minimum margin.
    • When you have one or more open trades, your broker continually calculates theunrealized value of your positions to determine your Net Asset Value (NAV) .
    • Should your open positions lose so much potential value that the remaining funds in your account – that is, your remaining collateral – is in danger of falling below the minimum margin limits, you could receive a margin call.
    • Individual brokers may handle margin calls differently. For example, you could receive a request to add more funds to your account, or your broker may simply close your open positions at the current market price to limit further losses.
    • In either case, you could end up losing the entire balance of your account and may even owe additional funds to cover your losses.

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    Risks Involved in Forex Trading

    • Forex trading – like any form of trading – is not without risk.
    • Some may even suggest that trading in the forex market actually carries above-average risk.
    • The one rule you must hold above all else is to trade only using your risk capital.
    • In other words, never trade more than you can afford to lose.

    Deal Only with Reputable Forex Brokers

    • Unfortunately, in the early days of online forex trading, fraud was an all-too common problem.
    • Great inroads have been made to clear out unscrupulous brokers, but you must still exercise caution when selecting a new broker.

    Insist Upon Regulation

    • When reviewing a forex broker, insist upon regulation.
    • You should only trade with a broker that is a member in good standing with a recognized regulator such as those listed in the table below:

    Reputable Forex Regulators by Country

    Country Regulator
    United States Commodity Futures Trading Commission (CFTC)
    National Futures Association (NFA)
    Great Britain Financial Services Authority (FSA)
    Japan Financial Services Agency (FSA)
    Singapore Monetary Authority of Singapore (MAS)
    Hong Kong Hong Kong Securities Futures Commission (SFC)
    Canada Investment Industry Regulatory Association of Canada (IIROC)

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    Time Zone (Summer) EDT GMT   Time Zone (Winter) EDT GMT
    Sydney Open 6:00 PM 10:00 PM Sydney Open 4:00 PM 9:00 PM
    Sydney Close 3:00 AM 7:00 AM Sydney Close 1:00 AM 6:00 AM
    Tokyo Open 7:00 PM 11:00 PM Tokyo Open 6:00 PM 11:00 PM
    Tokyo Close 4:00 AM 8:00 AM Tokyo Close 3:00 AM 8:00 AM
    London Open 3:00 AM 7:00 AM London Open 3:00 AM 8:00 AM
    London Close 12:00 PM 4:00 PM London Close 12:00 PM 5:00 PM
    New York Open 8:00 AM 12:00 PM New York Open 8:00 AM 1:00 PM
    New York Close 5:00 PM 9:00 PM New York Close 5:00 PM 10:00 PM

    You can see that in between each session, there is a period of time where two sessions are open at the same time. From 3:00-4:00 am EDT, the Tokyo session and London session overlap, and from 8:00-12:00 am EDT, the London session and the New York session overlap.

    So, when should one trade and why?

    The best time to trade is when the markets are active and have the biggest volumes of trade, usually this is when the sessions overlap and two markets are open at the same time.

    Forex trades can be made at almost any hour of any day. There are just a few gaps over the weekend between market openings but other than that it’s an open market. What does this mean for the trader? Well, it’s just one of the advantages that forex trading has over other forms of trading. You have much more control over when you can trade and since the forex market can be so volatile being able to make trades whenever you want is extremely important.

 

 

 

 

 

 

 

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