The foreign exchange market grew out of the abandonment of the Bretton Woods Agreement and the progressive unwinding of the regime of fixed exchange rates in the 1970’s. According to the 2001 Bank of International Settlements (BIS) triennial survey, global turnover amounts to some $1,210bn per day, of which the majority is generated on the London market.
Direct foreign exchange transactions fall into three main categories: -
Spot: Forex transactions nor near-immediate settlement and delivery (32% of turnover)
Forward: For settlement and delivery at a future date (11%)
Swaps: Agreements to swap interest rate payment streams across currencies, with a switch back to the original currency holdings at a point in the future. Swaps represent the largest component of turnover (54%).
Indirect transactions in foreign exchange include:-
Options: The right but not the obligation to buy or sell a currency at a given rate of exchange at a future date
Contracts for Difference: Derivatives that are settled daily on the basis of the movement in the underlying currency
Spread Betting: Legally enforceable wagers between punters and licensed bookmakers where winnings and losses are based on the points movement of the currency multiplied by the stake per point.
SPOT TRADING FOR PRIVATE INVESTORS
Although spot currency trading is inherently governmental, commercial and institutional, the advent of the internet has opened up the spot market to private investors.
Forex trading holds several attractions for the private investor: -
• 24-hour dealing, 5 days a week
• A vast liquid market making it easy to exchange most currencies
• The ability to profit in rising or falling markets
• Recognised instruments for controlling risk
• Leveraged trading with low margin requirements
• Zero dealing commission
Forex Brokers
Private access to the forex market is provided by a community of margin brokers, market makers and licensed bookmakers who enable investors to trade on the strength of deposits representing a fraction of the value of underlying trades, known as “margin”.
UK forex margin brokers are regulated by the Financial Services Authority. It is possible to select a non-UK broker (e.g. Gain Capital, Saxo Bank) but these may be regulated elsewhere or not at all.
UK regulation is pretty perfunctory. The intermediary is required to establish that you are an “intermediate investor” - based on evidence of your investment experience (e.g. stockbroker trading statements) - who understands the risks of margin trading. Thereafter, online dealing is distinctly execution-only.
SPOT MARKET BASICS
The spot market has no centralised exchanges. All trades are “over-the-counter” deals between individual counterparties known to one another. The market is global and operates 24 hours a day, Monday to Friday. Daily trading commences in Wellington, New Zealand and follows the sun to Los Angeles before starting again.
Currency Pairs and the Rate of Exchange
Every foreign exchange transaction is an exchange between two currencies, each denoted by a unique three-letter code. Currency pairings are expressed as two codes usually separated by a division symbol (e.g. GBP/USD), the first representing the “base currency” and the other the “secondary currency”. The base currency is the one that you are buying or selling.
The exchange rate is the price of one currency in terms of another. For example GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can be exchanged for 1.5545 US dollars (the secondary currency).
Majors and Crosses
Pairings with the US dollar are known as the “majors”. The “big four” majors are: -
EUR/USD: euro/US dollar
GBP/USD: sterling/US dollar (known as “cable”)
USD/JPY: US dollar /Japanese yen
USD/CHF: US dollar/Swiss franc
Non-US dollar pairings are known as “crosses”. We can derive cross rates for GPB, EUR, JPY and CHF from the aforementioned major pairs. For example: -
EUR/JPY = (EUR/USD X (USD/JPY)
Bid-Offer Spread
As with other financial commodities, there is a buying (“offer” or “ask”) and a selling (“bid”) exchange rate. The difference is known as the “bid-offer spread” or “the spread”.
The spread is written in a particular format. For example, GBP/USD = 1.5545/50 means that the bid price of GBP is 1.5545 USD and the offer price is 1.5550 USD. The spread in this case is 5 points.
Buying and Selling
Every purchase of the base currency implies a sale of the secondary currency. Likewise, sale of the base currency implies the simultaneous purchase of the secondary currency. For example, when I sell GBP/USD, I am selling GBP and buying USD. Similarly, when I buy GBP I am simultaneously selling USD.
We can express this equivalence by inverting the GBP/USD exchange rate and rotating the bid and offer reciprocals to derive the USD/GBP rate. For example, if GBP/USD = 1.5545/50 then
USD/GBP = 1/1.5550 (bid)/(1/1.5545 (offer) = 0.6431/33
Units of Trading
The basic unit of trading for private investors is known as a “lot” which represents 100,000 units of the base currency. Some brokers permit trading in mini-lots.
• The purchase of a single lot of GBP/USD at 1.5852 implies 100,000 GBP bought at 158,520 USD.
• The sale of a single lot of GBP/USD at 1.5847 entails the sale of 100,000 for 158,470 USD.
Margin
A private investor who purchases, say, GBP/USD is required to put down a deposit known as “margin”. Since the sale of one currency involves the purchase of another, the seller of GBP/USD will have bought a volume of USD and will also have to put down margin.
Normal margin requirement is between 1% and 5% of the underlying value of the trade.
With 5,000 USD in your margin account and a margin requirement of 2.5%, you can open positions worth 200,000 USD. If the funds in your margin account drop below the minimum required to support your open positions, then you may be asked to provide additional funds. This is known as a “margin call”.
Long and Short Positions
When you buy a currency, you are said to be “long” in that currency. Long positions are entered into at the offer exchange rate. When you sell a currency, you are said to be “short” in that currency. Short positions are entered into at the bid exchange rate.
Because of the symmetry of currency transactions, you are always simultaneously long in one currency and short in another.
To close out a position, you conduct an equal and opposite trade in the same currency pair through the same broker. For example, if you are long in one lot of GBP/USD you can close out that position by subsequently going short in one lot of GBP/USD (at the bid rate).
CASE STUDIES
The following examples illustrate long and short positions, the benefits and risks of margin trading and the workings of the margin account.
Going Long
Assume that you start with a clean slate and that the current GPB/USD (“cable”) rate is 1.5847/52.
• You expect the pound to appreciate against the US dollar, so you buy a single lot of 100,000 GBP at 1.5852 USD.
• The value of the contract is 100,000 X 1.5852 USD = 158, 520 USD. The broker wants margin of 2.5% in USD, so you must ensure that you deposit at least 2.5% of 158,520 USD = 3,963 USD in your margin account
• GBP/USD appreciates to 1.6000/05 and you decide to close out by selling your sterling for US dollars at the bid rate. Your gain is: -
100,000 X (1.6000 – 1.5852) USD = 1,480 USD
• Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate movement of less than 1%. This illustrates the positive effect of buying on margin.
• Had GBP/USD fallen to 1.5700/75, your loss would have been-
100,000 X (1.5852 – 1.5700) USD = 1,520 USD, a return of –38.35% illustrating the disadvantage of margin trading.
Going Short
You expect sterling to fall from GBP/USD = 1.5847/52 so you decide to sell one lot of GBP/USD.
• The value of the contract is 100,000 X 1.5847 USD = 158,470 USD.
• Your broker requires 2.5% of 158,470 USD as margin = 3,961.75 USD in cash
• GBP/USD falls to 1.5555/60 and you are sitting on a paper gain of: -
100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
• Your 2,870 USD paper gain is credited to your margin account (“variation in margin”) where you now have 6,831.75 USD. This enables you to maintain open positions worth 273,270 USD
• GBP/USD starts to rise. When it reaches 1.6000/05, you are sitting on a paper loss of: -
100,000 X (1.6005 – 1.5847) USD = 1,580 USD.
• Your margin account is debited by 1,580 USD (“variation in margin”), taking it down to 2,381.75 USD which is sufficient to support 2,381.75 USD/0.025 = 95,270 USD worth of open positions. Your current exposure, however, is:-
100,000 X 1.6005 USD = 160,050 USD
Your “shortage in equity” is therefore 160,050 USD - 95,270 USD= 64,780 USD
The broker makes a margin call for 2.5% of 64,780 USD = 1,619.50 USD.
• You eventually close out your position at GBP/USD = 1.5720/25. Your gain is:-
100,000 X (1.5847 – 1.5725) USD = 1,220 USD.
You have no more open positions, so you can withdraw the full 5,181.75 USD from your trading account in cash. Alternatively, you have enough margin to support 207,270 USD worth of new positions.
CONTROLLING RISK
Forex trading goes on for 24-hour a day, so how can you protect your positions when you are away from your screen?
There are a variety of automated orders that can be triggered at pre-set exchange rates and that can be deployed to control the downside and consolidate the upside:-
• Stop loss: An order to close out a position automatically when the bid or offer rate touches a given level.
For long positions, you issue a stop loss order below the current exchange rate. For a short position, you would set your stop loss above the current rate to be activated when the offer rate touches the trigger level.
A “trailing stop loss” is one that is adjusted behind a position as it moves into profit, to lock in gains.
In volatile markets, it may be impossible to execute stops at the precise limits.
• Take profits order (TPO): The opposite of a stop loss. For a short positions the TPO order will be set below the current exchange rate, and vice versa for long positions.
• Limit order: A buy or sell order that is activated when the current exchange rate passes beyond some preset threshold rate. Limit orders can be good for a specified period (e.g. a day, a month) or “good till cancelled”.
• One cancels the other (OCO): A combination of a stop loss and a limit order (or two limit orders) at opposite ends of the spread. When one is triggered, the other is terminated.
For long positions, the stop loss is set below the market spread and the limit sell order above the market spread. For short positions, the stop loss is set above the market spread and the limit order below.
ONLINE SPOT TRADING
The modern Electronic Broking System (EBS) delivers “straight through processing” with integrated quotation, transactional and administrative functionality.
EBS-type technology is now available to private investors who receive live streaming data and transact via their chosen brokers.
Hardware and Software
A private trader requires: -
• A margin account broker with internet access
• A computer terminal capable of running several programmes simultaneously
• Proprietary software to open and manage positions and to display technical analysis tools.
• A sufficient number of monitors to trade, display technical analysis and manage the margin account.
As an alternative to buying the full kit, you can rent a fully equipped trading desk from organisations like TraderHouse Network (www.traderhouse.net)
TRAINING
For those interested in “doing the knowledge”, TraderHouse Network runs 2-day residential training courses in forex spot trading for private investors. Courses combine tuition in technical analysis with simulated dealing in a live trading environment under the supervision of an experienced professional dealer.
For more information, visit www.traderhouse.net
June 2003
| An introduction to the foreign exchange market.
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