Lesson 27
Foreign Exchange Market

FOREX (FOReign EXchange market) is an international foreign exchange market, where money is sold and bought freely. FOREX was launched in the 1970s, when free exchange rates were introduced.

Only market participants determine the price of one currency against the other proceeding from supply and demand. As far as the freedom from any external control and free competition are concerned, FOREX is a perfect market. It is also the biggest liquid financial market. Money masses in the market constitute from 1 to 1.5 trillion US dollars a day. Transactions are conducted all over the world via telecommunications 24 hours a day from 00:00 GMT on Monday to 10:00 pm GMT on Friday.

FOREX is an objective market, because if some of its participants would like to change prices they would have to operate with tens of billions dollars. That is why any influence by a single participant in the market is practically out of the question. The superior liquidity allows the traders to open and/or close positions within a few seconds. The time of keeping a position is arbitrary and has no limits: from several seconds to many years. Although the daily fluctuations of currencies are rather insignificant, you may use the credit lines, that are accessible even to currency speculators with small capitals ($1,000—5,000), where the profit may be impressive.

The idea of marginal trading or leverage trading stems from the fact that in FOREX speculative interests can be satisfied without a real money supply by using trading with a margin deposit. This decreases overhead expenses for transferring money and gives an opportunity to open positions with a small account in US dollars, buying and selling a lot of other currencies. In marginal trading, each transaction has two obligatory stages: buying (selling) of currency at one price (opening the position), and then selling (buying) it at another (or at the same) price (closing the position).

Opening a position, a trader furnishes a deposit sum from 0.5 to 4 % of the credit line granted for the transaction. So, in order to buy or sell USD 100,000 for Japanese yens, you will not need the whole sum, but only from USD 500 to 2000 depending on your policy of controlling risks. When the position is closed, the deposit sum returns, and calculation of profits or losses is done. Marginal trading in an exchange market uses lots. 1 lot equals approximately $100,000, but to open it, it is necessary to have only from 0.5% to 4% of the sum.

For example, you have analyzed the situation in the market and come to the conclusion that the pound will go up against the dollar. You open 1 lot for buying the pound (GBP) with the margin 1% (1:1000 leverage) at the price of 1.49889 and wait for the exchange rate to go up. Some time later your expectations become true. You close the position at 1.5050 and earn 61 pips (about $405).

The major currencies traded in FOREX, are Euro (EUR), Japanese yen (JPY), British Pound (GBP), and Swiss Franc (CHF). All of them are traded against the USD.

While trading you can fix your profit or cut off your losses according to the orders Limit and Stop. Limit is set up higher than the current meaning of the price. Stop is set up lower than the current meaning of the price. With these commands the positions are closed without additional orders when the price reaches the agreed level.

In order to assess the situation in the market a trader has to be able to use fundamental and/or technical analysis, as well as to make decisions in the constantly changing current of political and economic information. Most small and medium players in financial markets use technical analysis. Technical analysis presupposes that all the information about the market and its further fluctuations is contained in the price chain. Any factor, that has some influence on the price, be it economic, political or psychological, has already been considered by the market and included in the price.

Technical analysis is a statistical and mathematical analysis of previous quotes and a prognosis of coming prices. A number of technical indicators have been installed into the PRO-CHARTS trading system. Analyzing the indicators one can come to the conclusion about further movements of the quoted currencies.

Fundamental analysis is an analysis of current situations in the country of the currency, such as its economy, political events, and rumors. The country’s economy depends on the rate of inflation and unemployment, on the interest rate of its Central Bank, and on tax policy. Political stability also influences the exchange rate.

At the same time one should not consider fundamental analysis just as an analysis of the economic situation in the country itself. A far bigger role in the FOREX market belongs to the expectations of the market participants.

Various prognoses and bulletins, issued by the participants, have a strong influence on the expectations. Very often an effect of the so-called self-fulfilling prophecy occurs when market players raise or lower the exchange rates according to the prognosis. But a deep and thorough fundamental analysis is available only for big banks with a staff of professional analysts and constant access to a wide field of information.

Reading a foreign exchange quote may seem a bit confusing at first. However, it’s really quite simple if you remember two things: 1) The currency listed first is the base currency and 2) the value of the base currency is always 1.

The USD is the centerpiece of the Forex market and is normally considered the ‘base’ currency for quotes. In the «Majors», this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 110.01 means that one U.S. dollar is equal to 110.01 Japanese yen.

When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote increases to 113.01, the dollar is stronger as it will now buy more yen than before.

The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.7366, meaning that one British pound equals 1.7366 U.S. dollars. In these three currency pairs, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, Euro or Australian dollar.

Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.

When trading forex you will often see a two-sided quote, consisting of a ‘bid’ and ‘offer’. The ‘bid’ is the price at which you can sell the base currency (at the same time buying the counter currency). The ‘ask’ is the price at which you can buy the base currency (at the same time selling the counter currency).

Foreign exchange quotes are a relation between currencies.

USDJPY – the cost of $1 in Japanese yens.

EURUSD – the cost of Euro 1 in US dollars.

That is, quotes are expressed in the units of the second currency for a unit of the first one. For example, quote USDJPY 108,91 shows that $1 costs 108,91 Japanese yens. Quote EURUSD 0.9561 shows that 1 Euro costs 0.9561 US dollars.

The last figure in the quote is called «pip». The cost of the pip is different for every currency, and depends on the leverage and current quote.

GBPUSD and EURUSD are direct quotes, i.e. when the chart goes up, GBP and EUR become more expensive, and when it goes down, the currencies become cheaper. USDCHF and USDJPY are backward quotes, and when the chart grows, prices on CHF and JPY fall, and when the chart goes down, the prices grow.

On direct quotes you buy according to ASK and sell according to BID. With backward quotes, you buy according to BID and sell according to ASK.