FOREXMADESIMPLE:ABEGINNER'SGUIDETOSHAREMARKETSUCCESSTableofContents

Chapter1:Historyofforeignexchange

Introductionofthegoldstandard

MajorinfluencesonforeignexchangesinceWorldWarII

TheBrettonWoodsAccord

TheNixonShock

TheSmithsonianAgreement

Free-floatingcurrencies

Currencyreserves

TheEuropeanCommunityandtheintroductionoftheeuro

Recentgrowthofforeignexchangemarkets

Interestratevolatility

Internationalbusinessoperations

Increasedinternationaltradeandtheuseofcurrencyhedging

Automateddealingsystems

Theinternetandretailtraders

Chaptersummary

Chapter2:Majorcurrencies,economiesandcentralbanks

Majorworldcurrencies

TheUnitedStatesdollar

Theeuro

TheJapaneseyen

TheBritishpound

TheAustraliandollar

TheSwissfranc

TheCanadiandollar

Centralbanks

Monetarypolicy

Interestrates

Openmarketoperations

Reserverequirements

Centralbanksandtheforeignexchangemarket

Repurchaseagreements

Foreignexchangeintervention

Theriseofcentralbanks

USFederalReserveSystem

EuropeanCentralBank

BankofJapan

BankofEngland

ReserveBankofAustralia

SwissNationalBank

BankofCanada

Chaptersummary

Chapter3:Theforeignexchangemarketsandmajorparticipants

Forexmarketparticipants

Theinter-bankmarket

Companiesandbusinesses

Hedgefunds

Investmentmanagementfirms

Retailforeignexchangebrokersandtraders

Variouscurrencymarkets

Theforwardsandswapmarket

Swaps

Currencyfutures

Thespotmarket

Chaptersummary

Chapter4:Retailforexdealersandmarketmakers

Forexmarketstructure

Retailforexdealers

Marketmakersordealingdesks

Retailforexdealersornon-dealingdesks

Choosingaretailforexdealerthatsuitsyou

Aretheyregulated?Ifso,inwhichcountry?

Whatistheircapitalisation?

Howuser-friendlyandreliableistheirtradingplatform?

Whatcustomersupportdotheyprovide?

Whattypesofaccountsdotheyoffer?

Whatleverageisofferedandwhatistheirmargincallpolicy?

Chaptersummary

Chapter5:Themechanicsoftradingforex

Tradingforexistradingmoney

Themechanicsofforextrading

Baseandquote(orcounter)currencies

Currencypairs

Longorshort?

Understandingpips

Lotsizes

Example1

Example2

Example3

Thebid/offerspread

Howthetraderandthedealercanbothmakeaprofit

Fractionalpips

Marginandleverage

Whentotradeforex

Chaptersummary

Chapter6:Howtoplaceaforextrade

Placingatrade

Openingatradeatmarket

Usingstopandlimitorderstoenteratrade

Rollover

Thecarrytrade

Chaptersummary

Chapter7:Currencyfutures

Themechanicsoftradingcurrencyfutures

Longorshort?

Novation

Standardisedcontractsandspecifications

Delivery(ormaturity)date

Settlement

Contractsize

Understandingtickvalues

E-microcurrencyfutures

Bid/askspread

Marginandleverage

Spotforexandcurrencyfuturescompared

OTCversusregulatedexchange

Lotsizesandspecifications

Pipsandticks

Brokers,dealersandmarketmakers

Liquidityandtransparency

Leverageandmargin

It’sallaboutchoice

Chaptersummary

Chapter8:Macroeconomicsandhowitaffectsforex

Economictheory

Purchasingpowerparitytheory

Balanceofpaymentstheory

Realinterestratedifferentialtheory

Economicdataandindicatorsthataffectforeignexchangevalues

Economicindicators

Grossdomesticproduct

Balanceoftrade

Industrialproduction

Durablegoodsorders

Constructionindicators

Retailsales

Consumerconfidenceindex

InstituteforSupplyManagementIndex

ConferenceBoardLeadingEconomicIndex®

Inflationindicators

Consumerpriceindex

Producerpriceindex

CommodityResearchBureauFuturesIndex

Employmentindicators

Non-farmpayrolls

EmploymentCostIndex

Importanteconomicindicatorsforthemajorglobaleconomies

ImportanteconomicindicatorsfortheEurozone

ImportanteconomicindicatorsforJapan

ImportanteconomicindicatorsfortheUnitedKingdom

ImportanteconomicindicatorsforAustralia

ImportanteconomicindicatorsforSwitzerland

ImportanteconomicindicatorsforCanada

Chaptersummary

Chapter9:Moneymanagementforforex

Swingingforthefences

Defininglosses

Settingstop-losslevels

Howmuchcapitalcanyouaffordtolose?

Usingleverageandpositionsizing

Leverageandsmallaccounts

Chaptersummary

KelButcher

First published 2011 by Wrightbooks an imprint of John Wiley & SonsAustralia,Ltd

42McDougallStreet,MiltonQld4064

OfficealsoinMelbourne

Typesetin11.5/13.4ptBerkeley©KelButcher2011

ThemoralrightsoftheauthorhavebeenassertedNationalLibraryofAustraliaCataloguing-in-Publicationdata:Author:Butcher,Kel.

Title:Forexmadesimple:abeginner’sguidetoforeignexchangesuccess/Kel

Butcher.

ISBN:9780730375241(pbk.)

Notes:Includesindex.

Subjects: Foreign exchange. Foreign exchange market. Foreign exchangefutures. Investments—Computer network resources. Electronic trading ofsecurities.

DeweyNumber:332.45

Allrightsreserved.ExceptaspermittedundertheAustralianCopyrightAct1968(for example, a fair dealing for the purposes of study, research, criticism orreview), nopart of this bookmaybe reproduced, stored in a retrieval system,communicatedortransmittedinanyformorbyanymeanswithoutpriorwrittenpermission.Allenquiriesshouldbemadetothepublisherattheaddressabove.

CoverdesignbyPeterReardonPipelineDesign<www.pipelinedesign.com.au>PrintedinAustraliabyLigareBookPrinter10987654321

Disclaimer

Thematerial in thispublication isof thenatureofgeneral commentonly, anddoes not represent professional advice. It is not intended to provide specificguidanceforparticularcircumstancesanditshouldnotbereliedonasthebasisforanydecisiontotakeactionornottakeactiononanymatterwhichitcovers.Readersshouldobtainprofessionaladvicewhereappropriate,beforemakinganysuch decision. To the maximum extent permitted by law, the author andpublisherdisclaimall responsibilityandliability toanyperson,arisingdirectlyor indirectly from any person taking or not taking action based upon theinformationinthispublication.

Thesecretofsuccessisconstancyofpurpose.

BenjaminDisraeli

Acknowledgements

My thanks as always go to the staff atWrightbooks, and in particularKristenHammond,forallthehelpandsupportingettingthisbookfromconcepttobookinashortspaceoftime.IwouldalsoliketothankFXCMfortheuseofvariousscreenshots in thisbook.GlenLarsonatGenesisFTdeservesspecialmentionforthedevelopmentoftheworld’sbestchartingprogram,TradeNavigator.

Iamalwayshonouredtobeabletowriteabookandcan’tdoitwithout thesupportofmywife,Cate,andmyboys,JesseandOllie,andtheinputandsharedexperiencesofthehundredsoftradersandothermarketparticipantsthatIhavespokenandcorrespondedwithovermanyyears.

AbouttheauthorKelButcherisaprivatetrader,entrepreneurandinvestor.Kelhasmorethan20years’experienceinfinancialmarkets,tradingshares,

futures,options,warrantsandCFDs.Heworksasaconsultanttoamanaged

fund,aboutiquetradingcompanyandashare-tradingsoftwaredeveloper.KelisaregularcontributortoYourTradingEdgemagazineandistheauthorofAStep-by-

StepGuidetoBuyingandSellingSharesOnlineand20MostCommonTrading

MistakesandHowYouCanAvoidThem.HealsofeaturedinTheWileyTrading

Guide.Passionate about moneymanagement, risk management and position-sizing

techniques, Kel acts as a mentor and coach to fellow traders. He can becontactedbyemailat<kel@tradingwisdom.com.au>.

Whenhe’s not trading,Kel enjoys snowboarding,mountain bike riding andsurfing.HelivesontheNSWCentralCoastwithhiswifeCateandhistwosonsJesseandOllie.

Preface

Derivedfromthewords foreignandexchange, forex(oftenabbreviatedsimplyto FX) is the practice of trading currencies or money. The foreign exchangemarket,alsoreferredtoasFOREX,Forex,retailforex,FX,marginFX,spotFXorjust‘spot’,isthelargestfinancialmarketintheworld.DailytradingvolumesareapproachingUS$4trillionaday—that’smorethanthreetimesthetotaloftheworld’sstocksandfuturesmarketscombined.

The forex market is an over-the-counter (OTC) market. This means that,unlike stock markets and futures markets, there is no central exchange orspecificplacewheretradesoccurandordersarematched.Instead,forexdealersand market makers are linked around the globe and around the clock bycomputerandtelephone,creatingonehugeelectronicmarketplace.

Once the domain of the large hedge funds, major corporations andinternational banks, the forex market has become available to retail tradersmostly because of the internet, which has allowed the development andevolutionofonlinetradingplatforms,sothatmanyfirmshavebeenabletoopenuptheforeignexchangemarkettoretailclients.Theseonlineplatformsnotonlyallow instant execution into themarket, but also provide charts and real-timenewsservices.Thisallowstraderstokeepabreastofnewsunfoldingaroundtheglobeas ithappens.The resulthasbeenahuge surge involumeofcurrenciestraded as retail clients become aware of the benefits of trading a market thattradesvirtuallycontinuouslyfromMondaymorningAustralian timeuntilearlySaturdaymorningSydneytime.

Theforexmarketallowsyoutoactivelyengageinonlinetradingusingbrokerplatforms to buy and sell currencies. The use of leveragewhen trading in theforexmarketmeansthatasmallamountofmoneycanbeusedtocontrolmuchlargerpositions thanwouldbepossiblewithout theuseof leverage.Butwhileleveragecanhelpmagnifyreturns,italsomagnifieslosseswhentheyoccur.

Before throwingyourselfhead first into realmoney tradingyoushould takethe time to familiariseyourselfwith theprinciplesof foreignexchange tradingandensureyouhaveafullunderstandingofhowitallworks.Itisalsoimportant

tounderstandtheevolutionofforeignexchangeandsomeofthekeymilestonesinthedevelopmentofthismarketintowhatitistoday.So,let’sgetstarted.

Chapter1:HistoryofforeignexchangeTherootsofmodern-daycurrencytradingcanbetracedbacktotheMiddleAgeswhen countries with different currencies began to trade with each other.Paymentsforthesetransactionsweregenerallymadeingoldorsilverbullionorcoinsbyweight.Transactionsweremadethroughmoney-changersoperatinginthemajortradingcentresandmarketplaces.Theirmainrolesweretoweighthebullionorcoinswithadegreeofprecisionandtodeterminetheauthenticityofthecoinsbeingexchanged.

Over time, a system of transferable bills of exchange evolved for use bytradersandmerchants,reducingtheneedforthemtocarryaroundlargeamountsofgoldorsilverbullionorcoins.

Introductionofthegoldstandard

Aseconomiesbegantoexpandandinternationaltradegrew,sotoodidtheneedto make transactions simpler and add stability to the exchange of currenciesaround the globe. Payments made using gold and silver were not onlycumbersome,butwerealsoaffectedbypricechangescausedbyshiftsinsupplyanddemand.

TheBank ofEngland took the first steps to stabilise its country’s currency.TheBankCharterActof1844establishedBankofEnglandNotes,whichwerefullybackedbygold,asthelegalstandardforcurrency.

In1857,USbankssuspendedpaymentsinsilver,whichithadusedsincetheintroductionofasilverstandardin1785,assilverhadlostmuchofitsappealasastoreofvalue.Thishadadisastrouseffectonthefinancialsystemandisseenbymany as a contributing factor to theAmerican CivilWar. In 1861 theUSgovernmentsuspendedpaymentsinbothgoldandsilver,andbegan,throughthegovernment central bank, a government monopoly on the issue of newbanknotes. This gradually began to restore stability to the country’s financialsystem, as the banknotes began to be accepted as a single store of value—unlikethesupplyofgoldandsilver,thesupplyofthesenotescouldberegulated.

Following the American Civil War, as the US economy expanded andinternational trade increased, therewas a dramatic increase in the demand forcredittofacilitatetradeandfinancerapidlyexpandingworldeconomies.

Themainaimoftheimplementationofthegoldstandard,wherebycurrenciesare linked to the price of gold, was to guarantee the value of any currencyagainst that of another. Because countries participating in the gold standardmaintainedafixedpriceforgold,currencyexchangerateswerethusfixedtothegoldprice.Eachcountryalsohadtomaintainadequategoldreservestobackitscurrency’svalue,whichprovidedahighlevelofstability.

TheBritish pound, for example,was fixed at £4.2472per ounce of gold (1ounceisequaltoabout28grams),whiletheUSdollarwasfixedat$20.67perounceofgold.SotheexchangeratewasessentiallyfixedatUS$4.8667per£1(US$20.67/£4.2472=US$4.8667).TipThe use of a gold standard to control monetary policy (the use of interest rates to slow or grow aneconomy) and its impact on inflation, unemployment and economic growth has many economicimplicationsthatarebeyondthescopeofthisbook.

Ifthesupplyofgoldremainsrelativelystable,thensodoesthesupplyofmoney.Theuseofagoldstandardessentiallypreventsacountryfromprintingtoomuchmoney,therebylimitinginflation,butatthecostofhigherunemployment.

Fromtheperspectiveoftheforexmarket,theuseofagoldstandardimpliesasystemoffixedexchangeratesbetweencountries.Ifallcountriesareonthegoldstandard, then there is really only one ‘real’ currency— the price of gold—fromwhichthevalueofallcurrenciesisdetermined.Thegoldstandardleadstostability in foreign exchange rates, which is often cited as one of the biggestbenefitsofusingthestandard.

The stability that results from use of the gold standard is also one of itsbiggestdrawbacks,becauseitpreventsexchangeratesfromrespondingfreelytochangingcircumstancesindifferentcountries.TipAgoldstandardlimitsthemonetarypoliciesacountry’scentralbankcanusetostabilisepricesandothereconomicvariables,resultinginsevereeconomicshocks.

After a long period of relative stability, the gold standard broke down at the

beginningofWorldWar Ias the largerEuropeanpowerswere forced to focustheir spendingonmilitaryprojects,which led to theprintingofexcessmoney.Theoutbreakofwaralsointerruptedtradeflowandthefreemovementofgold,underminingtheabilityofthegoldstandardtofunctionasitshould—allowinggoldtoflowbackandforthbetweencountriestoensureastablecurrencybase.

Thegoldstandardwasbrieflyreinstatedbetween1925and1931astheGoldStandardExchange.FacingmassivegoldandcapitaloutflowsasaresultoftheGreat Depression, Britain departed from the gold standard in 1931, and thislatestversionofthegoldstandardbrokedown.

Bythemid1930sLondonhadbecometheglobalcentreforforeignexchangeand the British pound served as the currency both to trade and to keep as areservecurrency.Foreignexchangewasoriginallytradedontelexmachines,orbycable,earningthepoundthenicknamecable.

MajorinfluencesonforeignexchangesinceWorldWarIIThe realgrowthof the forexmarkethas takenplaceasa resultofeventsafterWorldWar II. The abandonment of the gold standard and the war effort haddevastated the British and other European economies. The British pound hadalsobeendestabilisedbythecounterfeitingactivitiesoftheNazis.

Instarkcontrast totheaffectsofWorldWarIIontheBritishpound, theUSdollar was transformed from a dismal failure after the 1929 stock marketcollapse, to the leading benchmark currency to which most internationalcurrencieswerecompared.TheUSeconomywasonfire.TheUSemergedasaglobaleconomicpowerhouseandtheUSdollarbecamethepre-eminentglobalcurrency.

TheBrettonWoodsAccordWhile thewar raged inEurope, representativesof theBritish andUS treasurydepartmentswerealreadyplanningforpostwareconomicreconstruction.Central

tothiswastheabilitytoallowfreetradetobeconductedwithoutwildcurrencyfluctuations or sudden depreciation, coupled with an effective system ofinternationalpayments.

During July of 1944 the 44 allied nations met for the United NationsMonetaryandFinancialConferenceatBrettonWoodsintheUS.Thecountriesagreed to a number ofmeasures designed to stabilise the global economy andcurrencymarketsintheaftermathofthewar.Chiefamongthesemeasureswasan obligation for each country to adopt a monetary policy that pegged itscurrency to the US dollar. Each currency was permitted to fluctuate plus orminus1percentfromthis initialvalue.Whenacurrencyexceededthis range,and at specified predetermined intervention points, the central bank of thecountryhadtoeitherbuyorsellthelocalcurrencyinordertobringitbackintotherange.ThisbecameknownastheBrettonWoodssystem.

As theUS dollarwas pegged to the value of gold atUS$35 per ounce, allcurrencieswereeffectivelystillpeggedtothegoldprice.TheUSdollarwasnowassumingtheroleplayedbygoldunderthegoldstandard.TheUSdollarbecametheworld’sreservecurrency.

In order to regulate the member countries’ currencies, and to ensureprocedures and rules put in place at Bretton Woods were adhered to, theInternationalMonetary Fund (IMF) and InternationalBank forReconstructionandDevelopment (IBRD), now theWorld Bank,were established. Themajorpurpose of the IMF was to maintain a stable system for buying and sellingcurrenciesbetweencountries,andtoensurepaymentsforinternationaltradeandexchangewereconductedinatimelyandsmoothmanner.

ThemaintasksoftheIMF(asnotedonitswebsite)wereandstillareto:

⇒provideaforumforcooperationoninternationalmonetaryproblems

⇒facilitatethegrowthofinternationaltrade,thuspromotingjobcreation,economicgrowthandpovertyreduction

⇒promoteexchangeratestabilityandanopensystemofinternationalpayments

⇒lendcountriesforeignexchangewhenneeded,onatemporarybasisandunderadequatesafeguards,tohelpthemaddressbalanceofpayments

problems.

TheNixonShockThedecisionnowreferredtoastheNixonShockwasaseriesofmeasurestakenbyUSpresidentRichardNixonthatdestroyedtheBrettonWoodssystemandledtothefree-floatingcurrencysystemthatexiststoday.

By1970thecostoftheVietnamWarandincreaseddomesticspendingwerecausingarapidrise in inflation in theUnitedStates.TheUSwasalsorunningboth a balance of payments deficit and a trade deficit, causing other BrettonWoodsmembercountriestobecomeconcernedaboutAmerica’sabilitytopayitsdebts.TocoverthisspendingtheUSwasprintingexcessmoney,resultinginadollar glut. In effect the US dollar was over-valued compared with the othercurrenciesthatwerepartoftheBrettonWoodsAccord.

Atthesametime,goldwastradingatahigherpriceonthefreemarketthanthe rate atwhich itwas pegged against theUSdollar.This allowed traders tomakeanarbitrageplaybybuyingpeggedgoldwithUSdollarsandsellingitatthehigherpricesprevailinginthefreemarket.ThiscombinationofeventssawgovernmentgoldcoverageoftheUSdollardeclinefromaround56percenttolessthan25percent.WhentheUSlifteditsquotaontheimportofoil,thisalsotriggeredfurthermassivedollaroutflowsfromtheUSeconomy.

InMay1971WestGermany,fearfulofbuildinginflationarypressuresinboththeGerman and global economies as a result of theUS trade and balance ofpayments deficit, became the first member country to opt out of the BrettonWoodssystem,andthevalueof theUSdollardeclinedby7.5percentagainstthe German (Deutsche) mark. During this period France accumulated almostUS$200millionworthofgold,andSwitzerlandUS$50millionofgold,furtherdepleting US gold reserves. In early August 1971, as the US CongressrecommendeddevaluationoftheUSdollartoprotectitfromwhattheyreferredtoasforeignpricegougers,SwitzerlandalsowithdrewfromtheBrettonWoodssystem.

On15August1971PresidentRichardNixonannouncedmeasurestocombattherampantinflationintheUSandstabilisetheeconomy.Theseincludeda90-daypriceandwagesfreeze,a10percentimportsurcharge,andthecancellation

of theconvertibilityofUSdollars togold.ThesedecisionsweremadewithoutconsultationwiththeothermembersoftheBrettonWoodssystem,andbecameknownastheNixonShock.TipFromaforeignexchangetradingperspective,thedroppingofthegoldstandardledtothefreefloatingofmostmajorworldcurrenciesandopeneduptheglobalfinancialmarkets.

TheSmithsonianAgreementDespiteabandoningtheBrettonWoodssystem,Nixonwasstilluncertainthatthefreemarketcouldallowatrueandfairrepresentationofacurrency’svalue.Likemany at the time, he was concerned that an entirely unregulated foreignexchange market could lead to currency devaluations and the breakdown ofinternationaltrade.

InDecember1971theG10(Groupof10)countriesagreedunderthetermsofthe Smithsonian Agreement to maintain fixed exchange rates without thebacking of gold. The G10 countries are Belgium, Canada, France, Germany,Italy,Japan,theNetherlands,Sweden,Switzerland,theUnitedKingdomandtheUnitedStates.TheUSdollarwasalso tobeallowed to floatwithina2.25percent range, insteadof just1per cent asunder theBrettonWoods system.Thefreemarket price of gold exploded tomore than $215 per ounce and theUStradedeficitcontinuedtogrow.Inlightoftheseissuesandahostofothers,theforeign exchangemarketswere closed in February 1972, and the SmithsonianAgreementcollapsed.When theforexmarkets reopened in1973 theUSdollarwasnotfixedtoanyunderlyingvaluemeasureanditsvaluewasnotconfinedtowithinanypredeterminedvaluationparameters.

Floatingthedollar,coupledwithrisingoilpricesresultingfromconflictintheMiddle East at the time, created stagflation in the US economy. Stagflationoccurs when unemployment and inflation are both high. The result was theintroductionofarangeofneweconomicpoliciesintheUSthatsawconfidencereturntotheUSeconomy.

Free-floatingcurrenciesThe death of the BrettonWoods system and the collapse of the Smithsonian

Agreement ultimately led to the system of free-floating currencies that existstoday.By1978thefreefloatingofcurrencieswasmandatedbytheIMF.Bythistime,foreignexchangemarketshadevolvedconsiderablyandallowedalaissez-faireapproachtointernationalcurrencytrade.Thetruefree-marketnatureofthismarket saw liquidity and volumes continue to grow,making foreign exchangetradingmore appealing for speculators and hedgers, as well as the traditionalusersofthesemarkets.

A free-floating currency’s value is a function of the current supply anddemand forces in the market, rather than a synthetic value created byintervention policies. Free-floating currencies can also be traded openly by allmarket participants and speculators. Free-floating currencies experience theheaviesttradingdemand.Whileafree-floatingcurrencyismucheasiertotradethanaregulatedormanipulatedcurrency,liquidityisalsoamajorconsideration.

CurrencyreservesBeforetheBrettonWoodsAccord,theofficialmeansofinternationalpayment,and thus theofficial international reserve,wasgold.Under theBrettonWoodssystemtheofficialreservecurrencyfortheglobalfinancialsystemwastheUSdollar.Between1944and1968theUSdollarcouldbeconvertedintogold,andfrom1968 to1973 central banks could convertUSdollars intogold, but onlyfromtheirownofficialgoldreserves.

SincethecollapseoftheSmithsonianAgreementin1973,nomajorcurrencieshavebeenconvertible intogold. Instead, countries and large corporationsnowhold currency reserves. Reserve currencies, or foreign exchange reserves, aresimply assets held in various currencies. Foreign exchange reserves areimportant indicators of the ability to repay foreign debt and for currencydefence, and are used to determine the credit ratings of nations. Holdingcurrency reserves in place of gold reserves led to a significant increase involumesand liquidity in the foreignexchangemarkets.Ascountriesand largecorporations buy and sell currencies in response to constantly changingeconomicandgeo-politicalevents,thisaddshugeliquiditytothemarket.

CurrentlytheeuroandJapaneseyenarealsoconsideredsafe-havencurrenciesduring periods of instability. The portfolio of reserve currencies a country or

financial institution may hold changes depending on international conditions.TheSwissfrancisoftenincluded,butattimesthiscanbeproblematicbecausethefranchaslowerlevelsofliquiditythantheUSdollar,euroandJapaneseyen.Theintroductionoftheeurocurrencyin1999hashadthebiggestinfluenceonthenumberofUSdollarsheldasreservecurrency.Since1999theproportionofUSdollarsheldinofficialreservecurrencybycentralbanksandotherfinancialinstitutionsaroundtheworldhasdroppedfromjustunder71percenttoslightlymorethan62percent,whiletheeurohasrisenfromjustunder18percentto27percent.TipTheUSdollarisstillthemostwidelyheldreservecurrency,anditisconsideredtohavereserve-currencystatus. The US dollar is still considered a safe haven in times of economic uncertainty and globalupheaval,becausetheUSisstillseenasasafeeconomybackedbytheUSTreasury.

TheEuropeanCommunityandtheintroductionoftheeuroMorerecently,theemergenceoftheeurocurrencyhashadadramaticimpactonforeign exchange markets. An understanding of the events leading up to therelease of the euro currency is important for understanding the role of theEurozone in the global economy and the euro currency in global foreignexchangemarkets.

The European Monetary Union was created as a result of a long andcontinuous series of efforts after World War II to create closer economiccooperationamongthecapitalistEuropeancountries.TheEuropeanCommunity(EC) commission’s officially stated goals were to improve inter-Europeaneconomiccooperation,createaregionalareaofmonetarystability,andactas‘apole of stability inworld currencymarkets’. The first steps in this rebuildingwere taken in 1950, when the European Payment Union was instituted tofacilitate the inter-European settlement of international trade transactions. Thepurposeofthecommunitywastopromoteinter-Europeantradeingeneral,andtoeliminaterestrictionsonthetradeofcoalandrawsteel,inparticular,asbothwereinhighdemandfollowingthewar.

The European Economic Community was established in 1957 under theTreatyofRome.Oneofitsmainobjectiveswastoeliminatecustomsdutiesand

other barriers that hindered free trade and movement between the membernations.At thesametimeitbegantosetuptradebarriersagainstnon-membernations.

In1969aconferenceofEuropean leadersset theobjectiveofestablishingamonetary unionwithin theEC in order to stimulateEuropean trade and bringtogether the member nations so they could compete successfully with thegrowingeconomiesoftheUnitedStatesandJapan.TheECaimedtoimplementacommonEuropeancurrencyby1980.

In1978thethenninemembersoftheECratifiedanewplanforstability—theEuropeanMonetarySystem(EMS).Thisnewsystem,implementedin1979,employed an exchange rate mechanism (ERM) to encourage participatingcountries to maintain their currency exchange rates within a defined range.ThesepermissiblelimitswerederivedfromtheEuropeanCurrencyUnit(ECU).TheECUwasabasketofcurrenciesoftheEuropeanCommunitymemberstatesused as the internal accounting unit within the EC and for some largeinternationalfinancialtransactions.

In1988a three-stageplanwasproposed toallowEUmembers to reachfulleconomic union, to advance social and economic unity within what becameknownastheEurozone,andtoincreaseitspresenceintheglobalfinancialarena.IncludedinthisplanwastheestablishmentoftheEuropeanCentralBankandasingle currency to replace existing national currencies, culminating in fullconvergence in the Economic and Monetary Union (EMU) or EuropeanMonetary Union as it is more generally known. The EMU is essentially theagreement among the member nations to adopt a single currency unit andmonetarysystem.TheseplanswereformalisedintheMaastrichtTreatyin1992.In 1993 the European Union (EU) was formally established with 15membernations.

In1999,more than40years after the ideawas first proposed, the eurowasintroducedasanall-Europeancurrencyby11of the then15memberstates. Itremained an accounting-only currency until 1 January 2002, when euro notesand coins were issued and individual national currencies, such as the FrenchfrancandtheGermanmark,begantobephasedout.

AswellasitsroleinhelpingcreateasingleEuropeanmarketplace,thesingle

eurocurrencyhasanumberofotherbenefits,whichinclude:

⇒theeliminationofexchangeratesandfeeswithintheEurozone

⇒pricetransparencybetweencountries

⇒easeoftravelforcitizens,andgoodsandservicesacrosstraditionalgeographicborders

⇒lowerinterestrates

⇒theformationofaliquidandrespectedinternationalcurrencythatisusedbyforeigninvestorsandtraders

⇒thecreationofasocialandpoliticalsymbolofintegrationandunity.

Theeuroisnowusedby16ofthe27EUmembersandaccountsformorethan25percentofglobalcurrencyreserves.ThememberstatesthatusetheeuroastheirsolecurrencyarereferredtoastheEurozone.

RecentgrowthofforeignexchangemarketsInadditiontothehistoricaleventsthatledtothedevelopmentandevolutionofglobal foreignexchangemarkets,somemorerecenteventshavecontributed tothe explosion in interest in trading foreign exchange not only among largefinancial institutions and banks, but also at the retail trader level. Foreignexchangetradinghasexperiencedspectaculargrowthinvolumesincecurrenciesbegan to free float in 1978. In 1977, when currencies were still regulated,averagedailyturnoverwasaroundUS$5billion.ThishadincreasedtoUS$600billionin1987,andreachedtheUS$1trillionperdaymarkinSeptember1992.AveragedailyturnoverintheforexmarketisnowapproachingUS$4trillion—anumber thatdwarfsallother financialmarkets.Currencyvolatilityand intra-daypricemovesaretheprimarydriversofthisexplosivegrowthinvolume,andtheycouldneverhaveoccurredunderaregulatedenvironment.

Someof themain developments that have contributed to the growth of this

market include interest rate volatility, international business operations,increasedinternationaltradeandtheuseofcurrencyhedging,automateddealingsystems,andtheinternetandretailtraders.

InterestratevolatilityEconomic globalisation and the increased importance and use of monetarypolicyhavehadasignificant impactoninterestrates.Economieshavebecomemuch more interrelated, exacerbating the need to change interest rates inresponse to global economic and geo-political events and to changes ineconomic conditionsbetween tradingpartners. Interest rates are alteredby thecentralbankineachcountrytoadjusteconomicgrowthandtocontrolinflation.Raising interest rates will slow spending and growth, while lowering interestrates generally leads to more spending and higher growth. Interest-ratedifferentialsbetweencountriesaffectexchangerates.TipA strong economy with low inflation and interest rates that are high relative to the country’s tradingpartnerswillexperienceariseinitscurrency’svalue.Aneconomythatisperceivedasbeingweak,andhavinglowinterestrates,willusuallyhaveaweakercurrency.

Themovementofmoneybetweencountriesandcurrenciestotakeadvantageofthese interest-rate differentials is a major contributor to both the volume andvolatilityofcurrency trades.Theprocessofbuyingahigh-yieldcurrency (onewithahighinterestrate)andsellingacurrencywithalowyield(onewithalowinterestrate)isreferredtoasacarrytrade,whichwillbediscussedindetailinchapter6.

InternationalbusinessoperationsBusiness globalisation and competition have intensified in parallel witheconomicglobalisationasbusinessessearchfornewmarketsforfinishedgoods,as well as cheaper input costs of labour and raw materials. The pace ofinternationalisation has expanded in recent decades as a result of a number ofmajorevents.TheseincludethefallofcommunismintheEasternBloccountriesand theSovietUnion,economiccrises inSouth-EastAsiaandSouthAmerica,and the rise of bothChina and India as global economic powerhouses. Theseevents have influenced the demand and supply of both raw materials and

finishedgoods.Asaresult,thesupplyanddemandofvariouscurrenciesduringthese periods is also affected, as wealth and asset protection measures areimplementedatbothacorporateandgovernmentlevel.

IncreasedinternationaltradeandtheuseofcurrencyhedgingThesuccessfulhandlingofforeignexchangetransactionsandtheuseofhedgingstrategiestoprotectagainstadversecurrencymovements,ortolockineitherthecostofrawmaterialsorthesalepriceoffinishedgoods,canaffecttheprofitsofbusinesses involved in theglobalmarket place.Theprofit from the successfulsale of a product in overseasmarkets can be seriously eroded due to adverseforeign exchange movements. Corporate and business interest in foreignexchangetransactionsandhedgingactivitieshasincreasedinlinewithincreasedinternational trade, adding substantially to thevolumeof currency transactionsundertaken. Many larger businesses and corporations may also participatespeculatively in the foreign exchange market in order to profit from tradingopportunities,inadditiontotheirhedgingactivities.

AutomateddealingsystemsThe introduction of automated foreign exchange dealing systems in the 1980sandelectronicmatchingsystemsinthe1990shadamassiveimpactonthespeedandsafetyofforeignexchangetransactions.Automatedonlinedealingsystemslink the interbank market electronically, allowing all major participants to beinterlinked24hoursadayandtotradevirtuallycontinuouslywithwhoeverisinthemarketatanyonetime.Automateddealingsystemsalsoallowlarge-volumetrades,aswellasfasterandmorereliablesimultaneoustradesthantelephoneandtelex transactions. These trades are also safer and more transparent, as bothparties to the transaction can see exactly what has happened. The electronicmatching systems developed and used by brokers have allowed thousands ofbrokers to access the foreign exchange market and provide foreign exchangetradingplatformstotheirclients.Thishasopenedtheforeignexchangemarketup to a vast number of retail traders and contributed significantly to the rapidexpansioninforeignexchangetradevolumesoverthepast10years.

TheinternetandretailtradersCoupledwith thedevelopmentofdealingandmatchingsystems, theadventofthe internet has opened up the foreign exchange market to retail traders andothers who can now trade online using a broker platform and an internetconnection. This has provided access to the foreign exchange market forthousands of speculators and traders, and added a large amount of intra-dayspeculative volume to the market. Once the domain of the large banks, fundmanagersandcorporations,theforeignexchangemarketisnowaccessibletoamuchwiderrangeofclientsusingvariousstrategiesandmethodsfortradingthemarkets,andaddingtothemarket’svolatilityaswellasitsvolumeandliquidity.Theongoingeducationoftradersandimprovementsintheunderstandingoftheforeignexchangemarketswillcontinuetoaddvolumetothemarketasmoreandmore traders are introduced to, and become confident with, trading foreignexchange.

Chaptersummary

⇒Therootsofmodern-daycurrencytradingcanbetracedbacktotheMiddleAges,whentradebetweencountrieswithdifferentcurrenciesbegan.

⇒Themainaimoftheimplementationofthegoldstandardwastoguaranteethevalueofanycurrencyagainstthatofanother.

⇒Thestabilitythatresultsfromtheuseofthegoldstandardisalsooneofitsbiggestdrawbacks,asitpreventsexchangeratesfromrespondingfreelytochangingcircumstancesindifferentcountries.Agoldstandardalsolimitsthemonetarypoliciesthatacountry’scentralbankcanusetostabilisepricesandothereconomicvariables,whichcancausesevereeconomicshocks.

⇒TherealgrowthoftheforeignexchangemarketplacehastakenplaceasaresultofeventsoccurringafterWorldWarII.

⇒TheBrettonWoodsAccordestablishedtheUSdollarastheglobalcurrency.

⇒ThedeathoftheBrettonWoodssystemandthecollapseoftheSmithsonianAgreementultimatelyledtothesystemoffree-floatingcurrenciesthatexiststoday.By1978thefreefloatingofcurrencieswasmandatedbytheInternationalMonetaryFund(IMF).

⇒ThecreationoftheEuropeanMonetaryUnionwastheresultofalongseriesofpost–WorldWarIIeffortsaimedatcreatingclosereconomiccooperationamongthecapitalistEuropeancountries

⇒In1999,morethan40yearsaftertheideawasfirstproposed,theeurowasintroducedasanall-Europeancurrencyby11ofthethen15memberstates.

⇒AveragedailyturnoverintheforeignexchangemarketisnowapproachingtheUS$4trillionlevel—anumberthatdwarfsthevalueoftradesinallotherfinancialmarkets.

⇒Thankstotheadventoftheinternetandtechnologicaladvancementsinrelationtotradingplatformsanddealingsystems,theforeignexchangemarketcannowbetradedbyamuchwidercommunityoftradersaroundtheglobeandaroundtheclock.

Chapter2:Majorcurrencies,economiesandcentralbanks

Whileyoumaybeitchingtostarttrading,ifyouaretobecomeacompetentandconfidentforextraderyouwillneedanunderstandingoftheunderlyingconceptsof foreign exchange to give you a solid foundation on which to build yourtradingbusiness.Understandingtherolesandusesofthemajor(andsomeoftheminor) currencies, the workings of the global economy, and the manyinterrelationships that exist will help your decision-making processes and thedevelopmentofyourtradingsystemorstrategy.

MajorworldcurrenciesAlthough all countries have their own currency, foreign exchange trading islimited to the currencies that have a global presence through their use ininternationaltradeandinvestment.Inthischapter,wewilllookatthesevenmostactivelytradedglobalcurrencies:theUSdollar,theeuro,theJapaneseyen,theBritishpound,theAustraliandollar,theSwissfrancandtheCanadiandollar.

TheUnitedStatesdollarTheUSdollar(USD,$)effectivelybecametheworld’sreservecurrencyundertheBrettonWoodsAccordof1944.AsaresulttheUSdollarisstilltheworld’smaincurrency,andmostglobaltradeoutsideEuropeisstillquotedinUSdollars.

TipUnderconditionsofinternationaleconomicandpoliticalunrest,theUSdollarisstillconsideredthemainsafe-havencurrency.Itisthemostactivelytradedcurrencyintheworld.

Asa resultof its imposed statusas thedefault reservecurrencyunderBrettonWoods,many smaller nations still use theUSdollar as their official currency.Thisprocess is referred toasofficialdollarisation.Somecountries thatuse theUSdollar includePanama,Bermudaand theBahamas,where theUSdollar isacceptedaslegaltenderalongwiththelocalcurrencyata1:1exchangerate.TheBritishdependenciesoftheBritishVirginIslands,andTurksandCaicosIslandsalso use the US dollar as official currency. More recently, some smallercountries,suchasElSalvadorin2001andEcuadorin2000,havealsoadoptedtheUSdollarastheirofficialcurrency.Whenitachievedindependencein2000,Timor-Leste(EastTimor)alsochosetheUSdollarasitsofficialcurrency.

OthercountrieslinktheircurrencytotheUSdollaratafixedexchangerate,known as a linked exchange rate system. Some examples include Barbadoswhere the localBarbadosdollar isconvertible toUSdollarsata2:1ratio,andHongKongwheretheHongKongdollarhasbeenlinkedtotheUSdollarsince1983 at between $7.75 and $7.85HongKong dollars to theUS dollar. SaudiArabiaalsopegsitscurrency,theSaudiriyal,totheUSdollarbecauseofitsroleintheinternationaloilmarket.

TipThe US dollar is also accepted as a second currency in some countries although it is not officiallyrecognised as legal tender. Examples include Peru, Uruguay and many South-East Asian countriesincludingVietnam,Myanmar andCambodia.ManyCanadian andMexican businesses also acceptUSdollars.

TheChineseyuanandtheUSdollar

AsChina’seconomycontinuestodevelop,manypeoplearetheorisingonwhatthiswillmeanforglobalmarketsandcurrencymarkets,particularlyhowitwillaffect theUSdollar.Perhapsoneof thebiggest issuesbe if theyuan(CNY,¥)becomesafree-floatingcurrencyandcanbetradedfreelyonforexmarkets,likeotheropenmarketcurrencies.Whileallofthisispurespeculationatpresent,it’shandytohavesomeunderstandingofthehistoryoftheyuananditsrelationshipwiththeUSdollar.

The Chinese yuan has generally been pegged to the US dollar. During the1980s,asChina’seconomybegantoopenup,theyuanwasdevaluedonseveraloccasions so the country could achieve export competitiveness. The officialexchangeratedeclinedfrom1.50yuanperUSdollar in1980to8.62yuanperUSdollar in1994.From1997toJuly2005theofficial rateremainedstableat8.27yuanperUSdollar.On21July2005theChinesegovernmentliftedthepegagainst the US dollar and replaced it with a managed floating exchange ratesystembasedonabasketofforeigncurrenciesrepresentingChina’smajorglobaltrading partners. According to Chinese government officials, this basket ofcurrenciesisdominatedbytheUSdollar,euro,JapaneseyenandSouthKoreanwon.OthercurrenciesincludedinthebasketincludetheBritishpound,Russianrouble,Thaibaht,Australiandollar,CanadiandollarandSingaporedollar.Underthis system, theyuan is allowed to floatwithin a narrowbandof 0.5per centaroundtheparitypricedeterminedbythePeople’sBankofChina(PBC).

InJuly2008, inthemidstof theglobalfinancialcrisis(GFC), theyuanwasunofficiallyrepeggedto theUSdollar.Chinamaintains that thepeggingof theyuantotheUSdollarisnecessaryinordertoprotectitsdevelopingbusinessesand economy, and to promote economic growth. This keeps Chinese exportscheaponworldmarketsandtipsthebalanceoftradeinChina’sfavour.ThisisasourceofongoingtensionwiththeUnitedStates,whicharguesthatChinaneedstodevaluetheyuantotipthetradebalancemoreinfavouroftheUnitedStates.

Thisisapoliticalandeconomicdebatethatmaycontinueforsometime.

TipTheChinesegovernmentsetsthevalueoftheyuanandallowsittotradeinatightrangeataround7.27yuantotheUSdollar.

TheeuroTheeuro(EUR,€)becametheofficialcurrencyoftheEurozonememberstatesof theEuropeanUnion (EU) in1999,and it isnow inuse in16of the27EUmember states.ThecurrentEurozonemembers (thosecountrieswithin theEUusing the euro as official currency) are Austria, Belgium, Cyprus, Finland,France,Germany,Greece, Ireland, Italy, Luxembourg,Malta, theNetherlands,Portugal, Slovakia, Slovenia and Spain. The euro is the world’s second mostactivelytradedcurrency.

Within the European Union, as a prerequisite for joining the Eurozone,Bulgaria,Denmark,Estonia,LatviaandLithuaniahavepeggedtheircurrencytothe euro. More than twenty countries that don’t belong to the EU have alsopeggedtheircurrencytotheeuro,includingmanyinmainlandAfrica.JustastheUS dollar is used as a peg for smaller countries, particularly those locatedgeographicallyclose to theUnitedStates,manyof thecountriesand territoriesusing the euro as a peg for their currency are geographically close to the EUcountries,orareformercoloniesorterritoriesofEUmemberstates,suchasthethree French Pacific territories of French Polynesia, New Caledonia, and theTerritoryofWallisandFutunaIslands.

TipCountrieswithsmallorweakereconomiesoftenpegtheircurrencytoamajorcurrencyliketheeuroorUSdollar.This isregardedasasafetymeasure,asthestrengthandstabilityof themajorcurrencywillsupportthelocalcurrencyandeconomy.Itmayalsohelppreventinflationandprovidepeaceofmindforforeigninvestors.

Theeuro is the second-largestglobalcurrency,as shown in table2.1 (onpage26). According to the Bank of International Settlements (BIS) the euro is thesecondmosttradedcurrencyintheworldaftertheUSdollar.AccordingtotheEuropeanCentralBankandtheIMF,inOctober2009theeurosurpassedtheUSdollarasthecurrencywiththegreatestcombinedvalueofbanknotesandcoinsincirculationintheworld,withmorethan€800billionnowincirculation.

AfteritsintroductionintotheglobalforeignexchangemarketatUS$1.18/€1on1January1999,thevalueoftheeurofellrapidlytoalowofUS$0.8252/€1inOctober 2000 because of concerns about its acceptance and the economicimplicationsofonecurrencyfor theEU.In lateSeptember2000 theEuropeanCentralBank,theBankofEngland,theBankofJapan,theBankofCanadaandtheUSFederalReservebeganacoordinatedmarketinterventionprogramaimedathaltingtheslideinthepriceoftheeuro.ThesefivecentralbanksusedUS$2billionoftheircurrencyreservestopurchaseeuros.Theycitedfourmainreasonsfor intervening in the market and halting the slide in the value of thefledglingcurrency:

1RisingoilpricesatthetimemeantadecliningeurowouldcauseinflationtoriseinEurope.

2AstrongUSdollarandafallingeurowouldimpactnegativelyontheUStradedeficitandthissituationwasalreadypromptingcallsformoreprotectionismintheUnitedStates.

3TheprofitsofUSandothermultinationalcompaniesoperatinginEuropewerebeingeroded.

4ThereputationoftheEurozoneandthenewmonetaryunionwasbeingdamaged.

The buying interventionworked and the value of the euro began to improve,regainingparitywiththeUSdollarinJuly2002.Theinitialdeclineinvalueandtheeffectsofthismassivebuyinginterventioncanbeseeninfigure2.1.

InMay 2003 the euro surpassed theUS$1.18/€1 value at its launch. Sincethen the euro has ebbed and flowed in line with economic and geo-politicalevents,whichhasseenitbecomeahighlyliquidandhighlytradedcurrency.

Sincetheintroductionoftheeuroin1999theimportanceoftheUSdollarasan international reserve currency has declined. Table 2.1 (overleaf) shows thecurrency composition of official foreign exchange reserves as reported by theIMF.Thetablehighlightstheriseinimportanceoftheeurofromaround18percentofreservesin1999tomorethan27percentin2009,andthefalloftheUSdollarfromjustunder71percentin1999toaround62percentin2009.TheUSdollar is still themost commonly held reserve currency,with its holdings stillstandingatmorethandoublethoseoftheeuro,althoughtheimportanceoftheeuroissteadilyrising.

Figure2.1:pricechartoftheeurofromlaunchin1999toOctober2010

Source:TradeNavigator©GenesisFinancialTechnologies,Inc.

TipFormer chairmanof theUSFederalReserveAlanGreenspan said in an interview inGermany’sSternmagazine in September2007 that the euro could replace theUSdollar as theworld’s primary reservecurrency. He said that it is ‘absolutely conceivable that the euro will replace the dollar as reservecurrency,orwillbetradedasanequallyimportantreservecurrency’.

Table2.1:compositionofofficialforeignexchangereservesinpercentageterms,1995to2009

Source:IMFCurrencyCompositionofOfficialForeignExchangeReserves.

TheJapaneseyenDespite amuch smaller internationalpresence thaneither theUSdollaror theeuro,theJapaneseyen(JPY,¥)isthethirdmosttradedcurrencyintheworld.Itisalsowidelyheldasareservecurrency,alongwiththeUSdollar,theeuroandtheBritishpound.

BoththeJapaneseeconomyandthevalueoftheyenwereseverelydamagedbyWorldWar II.Under theBrettonWoodsAccord, the value of the yenwasfixedat¥360/US$1,andthisexchangerateremainedinplaceuntil1971,whentheBrettonWoodssystembegantounravel.ThebeliefintheUnitedStatesthattheyenandseveralothercurrencieshadbecomeundervaluedledtotheactionsknownastheNixonShock,asdiscussedinchapter1,andledtothedevaluationof the US dollar in 1971. Japanese exports were seen as being too cheap ininternational markets, while imports into Japan were overpriced. Under theexchange regime proposed in the Smithsonian Agreement, the Japanesegovernment agreed to a new fixed exchange rate of ¥308/US$1. In 1973 theJapaneseyenbecameafree-floatingcurrency,alongwiththeothermajorworldcurrencies.

Despite theyenbecominga free-floatingcurrency, theJapanesegovernmentcontinued to interveneheavily in the foreign exchangemarket tomaintain theyen’s value against the US dollar. Most of this intervention was aimed atprotecting Japan’s rapidly growing industrial base from a rising yen. As anexport-driveneconomy,Japan,andthereforetheyen,ishighlysensitivetorisingenergycosts.During theearly1980sacurrentaccountsurplus in theJapaneseeconomy generated strong trade-related demand for the yen.But high interestrates in theUnitedStatesandcontinuingderegulationofcapitalmarketssawanet capital outflow from Japan, which increased the supply of yen in foreignexchangemarketsandensuredtheyenremainedweakagainsttheUSdollar.

In September 1985 the Plaza Accord (so called because the meeting tookplaceatthePlazaHotelinNewYork)wasagreedbetweenJapan,France,WestGermany, Britain and the United States. The five governments agreed tointervene in currencymarkets to depreciate theUS dollar against theGermanmarkandtheJapaneseyeninyetanotherattempttostimulatetheUSeconomy

outofrecession.Between1985and1987thevalueoftheUSdollaragainsttheyendeclinedbymorethan50percentasthecentralbanksofthesignatoriestothePlazaAccordspentanestimatedUS$10billioninthecurrencymarkets.TheeffectonthevalueoftheUSdollaragainsttheyenisshowninfigure2.2.

Figure2.2:effectofthePlazaAccord,1978to2003

Source:TradeNavigator©GenesisFinancialTechnologies,Inc.

The ideabehinddevaluing theUSdollarwas tomakeUSexports to itsmajortradingpartners inEuropeandJapancheaper, thusencouragingthesecountriesto buy more US-made goods. The Plaza Accord achieved this with the US’sEuropeantradingpartners,butfailedinalleviatingthetradedeficitwithJapan.This has been attributed to Japan’s somewhat protectionist import restrictions.The strengthened yen led to an asset and housing price bubble, and a seriousrecessioninJapanduringthe1990s.Manyeconomistsandanalystsrefertothisperiod as the lost decade— a period from which the yen has still not fullyrecovered.

From a forex trading perspective the yen is a highly liquid currency that istradedinanumberofthemajorcurrencycrossesincludingagainsttheUSdollar,theeuro,theBritishpoundandtheAustraliandollar.Thisisdiscussedindetailinchapter5.

Theyen is seen as a safe-haven currency in timesof economic turmoil andgeo-political unrest. It is also used as an interest rate carry trade currency,becauseoftheverylowinterestratesinJapan.Thecarrytradewillbediscussedinmoredetailinchapter6.

TheBritishpoundThepoundsterling,orthepound(GBP,£)asitismorecommonlyknown,isthefourthmosttradedcurrencyintheforeignexchangemarkets.Italsolaysclaimto being the oldest currency in continuous use,with its origins dating back tobefore the year AD 800. Before the outbreak of World War I, the UnitedKingdomwasperhapstheworld’sstrongesteconomy.Bytheendofthewaritisestimatedthatthecountrywasmorethan£850millionindebt,owedmostlytotheUnitedStates.Torestoresomestabilitytothecurrencyandtheeconomy,thepoundwas repegged to the gold standard at the prewar peg rate, but thiswasabandonedin1931duringtheGreatDepression,andthevalueofthepoundfellbyalmost25percent.

DuringWorldWarIIthepoundwaspeggedtotheUSdollarat£1/US$4.03,andthisrateremainedinplaceundertheBrettonWoodsAccord,untiltheBritishgovernment,inresponsetopressurethatthepoundwassignificantlyovervalued,devaluedthepoundby30percentinSeptember1949toavalueof£1/US$2.80Like all the other major currencies, the British pound became a free-floatingcurrencyin1973.Thepoundhadawildrideduringthe1980s,initiallyrisinginlinewithrisinginterestrates,crashingheavilyinthemiddleofthedecadeduringthedeeprecessionthatfollowed,andthenrisingagaintowardstheendof1989astheeconomyslowlyrecovered.InOctober1990,BritainjoinedtheEuropeanexchange ratemechanism (ERM) to ensure the poundwould not fluctuate bymorethan6percentagainstthevalueofotherEUmembercurrencies.

The ERM was introduced by the European Community as part of theEuropean monetary system (EMS) to achieve monetary stability and inpreparationfor the introductionof theeurocurrency.TheERMisessentiallyasemi-peggedexchangeratesystemthatallowsfixedcurrencyexchangeratestofluctuatewithin a tight band; it is used as part of theprocesses for evaluatingpotentialEurozonememberstates.

BlackWednesday

WithBritainhavingjoinedtheERM,thepoundwassetatavalueof£1to2.95Germanmarks(£1/DM2.95).UnderthetermsoftheERMitwastobeallowedtofluctuateby6percenteithersideofthisvalue.Thelowerlimitforthepound(thepointatwhichthegovernmenthadtointervenetosupport thepound)wassetatDM2.77.WithinterestrateshigherinGermanyandEuropeingeneralthaninBritain,theBritisheconomybeingbatteredbyadepreciatingUSdollar,andhigh and ever-increasing inflation, there was considerable pressure from allquarters forBritain to increase its interest rate in linewith theotherEuropeaneconomiesanddevalueitscurrency.

Financier George Soros’s hedge funds began short selling British pounds,believingthatcurrentexchangerateswereunsustainableandwouldhavetofallor be devalued. On 16 September 1992, what is now known as BlackWednesday,eventscametoahead.TheBritishgovernmentliftedinterestratesto15percentinanattempttopreventthepoundfallingfurther,anditwithdrewfromtheERM.But thesellingof thepoundcontinued.Soros’s fundhadshortsoldUS$10billionworthofpounds,anditisestimatedthattheprofitfromthesetradeswasaroundUS$1billion.Sorosbecameknowninfinancialcirclesasthemanwho‘broke’theBankofEngland.

ThewildjourneyoftheBritishpoundandtheeffectsofBlackWednesdayareshowninfigure2.3.

Figure2.3:thevalueoftheBritishpoundinthe1980sandtheeffectsofBlackWednesdayin1992

Source:TradeNavigator©GenesisFinancialTechnologies,Inc.

AsamemberoftheEuropeanUnion,Britaincouldusetheeuroasitscurrency,but thegovernmentcontinues toprocrastinateover the issue.DebatecontinuesonthesubjectandremainscontroversialwiththeBritishpublic,themajorityofwhom continue to support the use of the pound. In addition, it is doubtfulwhether the criteria required tomeet the use of the euro as defined under theMaastrichtTreatycouldbemetbyBritain.Forexample,thecurrentgovernmentdeficitasapercentageofGDPisabovethethresholdrequiredbytheEU.

TipThepoundandtheeurotradeindependentlyofeachother,andfluctuateagainsteachotheraccordingtovariationsininterestratesandeconomicconditionsbetweenBritainandEurozonemembers.Theredoes,however,appeartobeahighdegreeofcorrelationbetweenthemovementsintheexchangeratesofthetwocurrencieswhencomparedwiththoseofothermajorcurrencies,particularlytheUSdollar.

TheAustraliandollarThe Aussie dollar (AUD, $) is currently the fifth most traded currency. ThegeneralstabilityoftheAustralianeconomyandpoliticalsystemhascontributedto the increased interest in theAustralian dollar. Other factors that encouragetradingin theAustraliandollar include thecountry’sgeographical locationandexportbusinesswithAsiancountries,relativelyhighinterestrates, itsexposuretothecommoditycycle,andgovernment’sthegenerallackofinterventionintheexchangeratemechanism.

TipThe Aussie dollar is considered a commodity-based currency because of the country’s reliance on theexportofminerals,includinggold,andotherrawmaterials.

AsAustraliawasaBritishcolony, itsoriginalcurrencywas theBritishpound.ThiswasreplacedbytheAustralianpoundin1910,whichwasinturnreplacedby the Australian dollar in 1966, when the exchange rate was pegged to theBritish pound at AUD2.50/GBP1, reflecting the country’s historical andeconomictieswithBritain.In1967theAustraliandollarwaspeggedtotheUSdollar at AUD1/USD1.12. In 1971, following the breakdown of the BrettonWoodsAccord,AustraliapeggeditscurrencytoafluctuatingrateagainsttheUSdollar.In1974,inlinewithcontinuedconcernsregardingtheUSeconomyandadesiretoreducethefluctuationsassociatedwiththefloatingpegtotheUSdollar,Australiabeganvaluingthedollaragainstabasketofcurrenciescalledthetradeweightedindex(TWI).Atanyonetimetherewereupto22currencieswithintheTWI,theweightofeachbeingdependentontradevaluesbetweenAustraliaandeach country. This system remained in place until December 1983, whenderegulationoftheAustralianfinancialsystemsawtheAussiedollarbecomeafree-floatingcurrencyalongwiththeothermajorworldcurrencies,withitsvaluedetermined by supply and demand factors instead of government policyandintervention.

Sincebecomingafree-floatingcurrency,theAussiedollarhasrangedfromalowofAUD1/USD0.47inApril2001toahighofjustoverparityinNovember2010.

TheAustraliandollarhasauniqueandinterestingplaceintheglobalforeignexchangemarket.BecauseAustralia’s balance of trade is highly dependent oncommodity exports, includingminerals and agricultural products, the value oftheAustraliandollartendstobeinversetothoseoftheothermajorcurrencies.During global booms, when raw materials are needed for manufacturing andincreased consumption, the Aussie dollar tends to rally.When mineral pricesslump or demand for commodities slows down, the Aussie dollar declines invalue.

TipDuringtimesofeconomicuncertaintytheAussiedollarlosesitsappeal,andtradersandinvestorsmovebackintotheso-calledsafe-havencurrencies,includingtheUSdollar,theyenandtheeuro.

Increasing globalisation and deregulation means the Aussie dollar is alsoinfluencedbyinterestratedifferentials,risingandfallingglobalshareprices,andinternationalgeo-politicalconcernsandevents.Asaresult,theAustraliandollartends todisplaya fairlyhighdegreeofvolatility.Thisvolatilityand itsuniqueandunorthodoxplaceintheglobalfinancialsystemhavebeenmajorfactorsincontributingtoitsstatusasoneoftheworld’smostactivelytradedcurrencies.

OneofthemajorinfluencesontheAustraliandollarinrecenttimeshasbeenthe strengtheningcommoditymarket cycle and thehugedemand for resourcesfromChina.ThishashadapositiveimpactonthevalueoftheAustraliandollar,asitsresources-drivenexportcyclehascontinuedtoflourishevenastheUnitedStates and Europe have suffered from the after-effects of the global financialcrisis.Asian economies, particularlyChina’s, have been growing strongly andthedemandforAustralia’scommodityresourcescontinuestobehigh.

TheSwissfrancTheoriginsoftheSwissfranc(CHF,Fr)canbetracedbacktobefore1798.Itiscurrently the sixth most traded currency in the world. In the early 1800s anestimated 8000 different types of notes and coins were in circulation inSwitzerland. In 1848, the new Swiss federal constitution, which united thevarious cantons or states after a short civilwar, specified that only the newlyformed federal government could print money, thereby stabilising andcentralisingthebankingsystem.InMay1850theSwissfrancwasintroducedasthesolecurrencyunitforSwitzerland.

Along with France, Belgium and Italy, Switzerland formed the LatinMonetary Union in 1865, agreeing to value their currencies at a standard ofeither4.5gramsofsilveror0.29gramsofgold.Thismonetaryunionendedin1927, but the Swiss maintained the same valuation standard until 1936.Following devaluations of the British pound, French franc and US dollar inSeptember 1936, the Swiss franc experienced its one and only devaluation.Under the Bretton Woods system the Swiss franc was pegged at4.30521CHF/US$1,ortheequivalentof0.206418gramsofgold.

HistoricallytheSwissfranchasbeenconsideredasafe-havencurrency.MuchofthisideaisattributedtoahistorywithintheSwisseconomyofzeroinflationandtherequirementthataminimumof40percentofthecurrencyincirculationbe backed by gold reserves, creating a pseudo-gold standard, and the strengthand quality of the Swiss financial system. The gold cover enabled the SwissfranctoremainrelativelystableandalsogreatlycontributedtotheattractivenessoftheSwissbankingsystemtointernationalinvestors.

TipFollowing a referendum inMay 2000, the gold cover of the Swiss franc was reduced to 20 per cent,perhapsreducingsomeoftheappealoftheSwissfrancasasafe-havencurrency.Nonetheless,theappealoftheSwissfrancduringuncertaineconomictimes,andperiodsofeconomicandpoliticalupheavalandunrest,remainsduetothegoldreservesthatstillbacktheSwissfranc.

TheCanadiandollarTheCanadiandollar(CAD,$)iscurrentlytheseventhmosttradedcurrencyonglobalforeignexchangemarkets.AsaformercolonyofBritain,likeAustralia,Canada used the British pound as its currency from 1764 until around 1841,when the Canadian pound was adopted by some areas of Canada. Years ofdebate followed, with the majority of Canadians wishing to adopt a decimalcurrency system based on the US dollar, while boffins in London wanted tomaintain use of theBritish pound throughout theBritishEmpire. In 1853, thegold standard was introduced, based on both British gold sovereigns andAmericangoldcoinsatarateof£1/US$4.8666withbothcurrenciesbeingusedinvariousCanadianprovincesorstates.In1858decimalcoinagewasintroducedandCanada’scurrencybecamealignedwiththeUSdollar.In1871,theCanadianparliament passed the Uniform Currency Act, replacing the currencies of theprovincesandtheCanadianpoundwiththeCanadiandollar,whichwaslinkedtothegoldstandard.

Havingabandonedthegoldstandardin1933,theCanadiandollarwaspeggedat CAD$1.1/US$1 duringWorldWar II. This was changed to parity in 1946.Then, following a devaluation in 1949, the value returned to the original pegvalueofCAD$1.1/$US1.UnlikeothercurrenciesintheBrettonWoodssystem,whosevalueswerepeggedtotheUSdollar,theCanadiandollarwasallowedtofloatfrom1950to1962.TheCanadiandollarreturnedtoafixedexchangeratein1962,whenitsvaluewassetatCAD$1/US$0.925,whichremained inforceuntil 1970, when the Canadian dollar once again became a free-floatingcurrency.

Like theAustralian dollar, the Canadian dollar is considered a commodity-basedcurrency,mainlybecauseofCanada’spositionasamajoroilexporter.Assuch,theCanadiandollarplaysasimilarroleinthenorthernhemispheretothatwhich the Australian dollar plays in the Asia–Pacific region — providingexposuretoaresource-basedeconomyandcurrency,andbeingheldasareservecurrencyasaresult.

TipMovements in the Canadian dollar exchange rate tend to be correlated to the price of crude oil andenergyprices, risingand falling in linewithmovements in thepriceof these energycommodities. It isoftenreferredtoasapetro-currencybecauseofthisclosecorrelation.

Becauseofthecountry’scloseproximitytotheUnitedStates,anditsrelianceontheUSformorethan80percentofitsexportsandmorethan50percentofitsimports, Canadians have a close interest in the value of theUS dollar, as therelativevalueshaveadirecteconomiceffectonCanada’seconomy.TheBankofCanadamaintains an official position thatmarket conditions should determinethevalueoftheCanadiandollar,anditclaimstohavenotdirectlyintervenedinforeignexchangemarketssince1988.Table2.2showstheworld’smost tradedcurrencies.

Table2.2:currencydistributionofglobalforeignexchangeasapercentageofmarketturnover,selectedyears1998to2001

Source:BankofInternationalSettlementsTriennialCentralBankSurvey,April2010.

Note:Thetotalofeachcolumnaddsupto200percent,ascurrenciesarealwaystradedinpairs—oneagainsttheother(formoreinformation,seechapter5).

CentralbanksAcountry’scentralorreservebankis thefinancial institutionthatoversees theoperation of the country’s banking andmonetary system. A central bank willusuallyhaveseveralareasofresponsibility,including:

⇒issuingthenationalcurrency

⇒regulatingthemoneysupply

⇒implementingmonetarypolicyandcontrollinginterestrates

⇒controllinginflationandpricestability

⇒maintainingcurrencyvalues

⇒ensuringstabilityofthefinancialsystemincludingregulatingandsupervisingthecommercialbanks

⇒actingaslenderoflastresorttocommercialbanks

⇒actingasthegovernment’sbanker

⇒managingforeignexchangereserves.

Anindependentcentralbankwillensurethereisnopoliticalinfluenceoverthecentralbank’spoliciesandthatthepoliciesofthecentralbankwillbeneutralinregard to the governing political regime. This is particularly important duringtimes of rising inflation or rising interest rates,which are politically sensitiveissues.

TipAs foreignexchange traders,wearemost interested in the roleof the centralbanks inusingmonetarypolicytoachieveacentralbank’sobjectivesintermsofcontrollinginflationandunemploymentlevels;itsinterventioninthefinancialsecuritiesmarketstoattempttocontrolandmanipulateinterestratesandthemoney supply (often referred to as openmarket operations); and its management of foreign exchangereservelevels,andtheimpacttheseactionshaveoncurrencyvalues.

MonetarypolicyMonetary policy is themanagement ofmoney supply to achieve the goals ofstable prices, low unemployment, low inflation and sustainable levels ofeconomicgrowth.Monetarypolicyishandledbyacountry’scentralbank,andisin sharp contrast to fiscal policy, which refers to government spending,borrowingandtaxation.Themonetarypolicytoolsavailabletoacentralbanktoachievetheseobjectivesandtoinfluencethelevelofeconomicactivityinclude:

⇒interestrates

⇒openmarketoperations

⇒reserverequirements.

All three have the effect of either expanding or contracting themoney supplywithinaneconomy.Monetarypolicyisreferredtoasbeingeitherexpansionaryorcontractionary.Expansionarymonetarypolicyrapidlyincreasesthesupplyofmoney in the economy and is used to encourage employment and economicgrowthbyloweringinterestrates.Contractionarypolicyisusedtocontrolrisinginflation or combat inflationary pressures by decreasing, or slowly increasing,themoneysupplybyraisinginterestrates.

TipMonetarypoliciesexistandcanbeimplementedbycentralbanksbecauseallthereservecurrenciesarefiatmoney.Fiatmoneyhasnointrinsicvalue,asitisnotlegallyconvertibletoanything,norisitfixedtoanystandardvalue.Itcanbecreatedfromnothingatanytimebythesimpleactofprintingmoremoney.

InterestratesInfluencing market interest rates is perhaps the most visible of the monetarypolicytoolsavailabletoacentralbank.Raisinginterestratesimpactsdirectlyonhouseholds through itseffectonmortgagepayments, and interestpaymentsonotherloansandconsumerdebt.Thisinturnservestoreduceconsumerspending,because less money is then available to consumers. Higher interest rates alsodiscouragenewborrowing,whichdecreases theamountofnewmoneycreatedthroughloans.Raisinginterestratesisacontractionarypolicydesignedtoslowdown spending and the economy, and to reduce inflationary pressures.Conversely,acutininterestratesmeansmoremoneyisavailableforconsumerspending,whichencouragesmoreborrowingandhasanexpansionaryeffectandapositiveimpactoneconomicgrowth.

TipTheeffectofchanging interest rateson thecurrencymarkets isgenerallyan increase in thevalueofacurrencyinlinewithinterestraterises,andadecreaseinthevalueofacurrencywheninterestratesarecut.

A contributing factor to the strength of the Australian dollar since the globalfinancial crisis has been the relatively high level of interest rates inAustraliacomparedwiththoseavailableintherestoftheworld.Higherinterestratesleadtoanincreaseinthedemandforthecurrencybyinvestorsandspeculators.Itisalsoan importantcomponentof thecarry trade,which isdiscussed indetail inchapter6.

OpenmarketoperationsOpenmarketoperationsinvolvethecentralbankbuyingandsellinggovernmentsecurities (mainlybonds) in theopenmarket.This isapolicymeasureused tocontroltheamountofmoneycirculatinginacountry’seconomy.Whenacentralbankbuysgovernmentsecurities,theeffectistoexpandthemoneysupplyandreduceinterestrates.Whenacentralbanksellsbonds,itsactiontakesmoneyoutof the economy, so the money supply is reduced and interest rates rise. Theeffect on the currency is similar to that of direct interest rate changeswhere,generallyspeaking,lowerratesleadtoafallinthecurrency,andhigherinterestrateswillcausethevalueofthecurrencytorise.

For thecentralbanktobuygovernmentsecuritiesorforeigncurrency in theopenmarket,itneedsnewmoneytobeavailabletopayforitspurchases,whichrequiresthebanktoprintorcreatethisnewmoney.Thisisonlypossiblebecauseofthefiatmoneysystemunderwhichtheglobaleconomynowoperates.

As most transactions are conducted electronically and money is held aselectronicrecords,theseopenmarketoperationsareconductedbyelectronicallydebitingor crediting accounts, rather than the printingor destructionof actualcashmoney.

If the central bank is buying in the open market, the seller’s account iscreditedelectronically,thusincreasingtheamountofmoneyinthataccountandintheeconomythroughthecreationofnewmoney.Ifthecentralbankissellingin the open market, the buyer’s account is debited electronically, whichdecreasestheamountofmoneyintheaccount,effectivelydestroyingthatmoneybyremovingitfromcirculationwithintheeconomy.

ReserverequirementsInmanycountriesthecommercialbanksandotherfinancialinstitutionsthatholdcustomercashdepositsare required toholdapercentageof thesedepositsandaccount balances on deposit at the central bank. This is known as the reserverequirement or cash reserve ratio. In the Eurozone, for example, this reserverequirement is currently2per cent.Thispercentage amountgenerally remainsstableandisseldomvaried,thoughitcanbeusedbythecentralbanktoaffectthemoneysupply.Ifthereserverequirementpercentageisincreased,thesupplyofmoneyin theeconomyisreduced,and interest rateswill rise inresponse tolessmoney being available. A rise in interest rateswill generally result in anincrease in the value of the country’s currency. Altering reserve requirementscauses a major long-term shift in the money supply, and so this method ofinfluencingtheeconomyisrarelyused.

CentralbanksandtheforeignexchangemarketIt’susefulforforeignexchangetraderstohavesomeinsightintotheoperationsofcentralbanksintheforeignexchangemarkets.Whilethisknowledgemaynothaveadirectimpactonyourtrading,itwillcertainlyhelpyouunderstandhowtheactionsofthecentralbankscanaffectandmovethemarkets.

RepurchaseagreementsRepurchaseagreements(alsoknownasreposorsaleandpurchaseagreements)aretransactionsingovernmentsecurities.Thepurchaseofasecuritycomeswithanagreementbythesellertobuyitbackataspecifiedfuturedateandatapricegreaterthanthesaleprice.Thedifferenceiseffectivelyaninterestpayment,andit is referred to as the repo rate. As the seller of the repo is effectively aborrower,andthebuyerisalender,arepoisacashtransactioncombinedwithaforwardcontract.Forwardcontractsareexplainedinchapter3.Whentransactedbyacentralbank,thepurchaseofreposaddstemporaryorshort-termreservestothe banking system; and then the reserves are withdrawn when the repo isrecalled.

TipThepurchaseofreposby thecountry’scentralbankgenerallyresults inareduction in thevalueof thecurrencyonforeignexchangemarkets.

Areverserepo,ormatchedsale,occurswhenthecentralbanksellsrepos.Theresult isatemporarydrainingoffundsfromthebankingsystem,whichpushesup interest rates, and increases the price of the currency on foreignexchangemarkets.

ForeignexchangeinterventionIntervention in theforeignexchangemarketsbycentralbanksandgovernmenttreasury departments is a sensitive issue. It is aimed at achieving andmaintainingorderlymarketconditions,thoughthedefinitionofwhatconstitutesorderly will depend on the economic goals of individual countries and therelativestrengthorweaknessofindividualcurrencies.Forthatreason,anydirectinterventionistypicallyconductedwithadegreeofstealthandsecrecy,andtheaction isgenerallynot announced to themarket, though there are examplesofcentralbanksopenlycollaboratingtoinfluencecurrencyvalues,suchasafterthePlazaAccordandtheinterventionbuyingoftheEuroasdiscussedabove.

Naked, or unsterilised, intervention is the direct buying or selling of acountry’s currencyby its central bank.Naked intervention leads to changes inthe money supply, and can add to inflationary and other pressures within aneconomy.Sterilisedintervention,bycomparison, involvesoffsettingtheimpactofinterventioninthecurrencymarketsonotherareasoftheeconomysellingorbuyinggovernment securities tooffset themoneyeithergenerated through thesaleofthecurrency,orthemoneyspentbuyingthecurrency.

TipSterilised intervention is generally the preferred option formost central banks, as it is has less directimpactontheunderlyingeconomy.Itisgenerallyusedasashort-termtomedium-termmeasure.

TheriseofcentralbanksCentralbankscametoprominencefollowingthecollapseof thegoldstandard.Before that, currencies were generally backed by gold or silver, whichmeantpricestabilitywaseasytomaintain.Monetaryexpansionwasthenonlypossibleif the amount of gold held by a country also increased. Regardless of thecreditworthinessofagovernment,thevalueofitscurrencywassupportedbythevalue of the underlying preciousmetal, and countries held stores of gold andsilver in order to support the value of the currency.With the advent of papermoney, and thepotential to simplyproducemoremoneywith aprintingpressand some ink, it too was backed by a ‘promise to pay’, which led to theintroductionofthegoldstandard.

Following the Great Depression of the 1930s, economist John MaynardKeynes introduced the concept of monetary policy to influence the supply ofmoneyinaneconomyandthusprovidewaysofinfluencingeconomicactivity.Again, this system isonlypossiblewith fiat currencies that arenotbackedbyanythingofvalueandhavenointrinsicvalue.

TipTheissuanceofcurrencymustalsobecontrolledbyamonopolymonetaryauthoritytoensuremoneyisnotsimplycreatedonanad-hocbasis.

Since the 1930s, it has become the role of the central banks to control theamount of money and credit available in an economy, and to achieve othereconomic requirements throughmonetary policy as discussed above. Amajorrole of a central bank operating a fiat money system is to maintain thepurchasingpowerofacurrencyanditsworthcomparedwithothercurrencies—this isacomplex task,asmostcountriesnowhaveopeneconomies thatallowthe free movement of capital, and free of currency movements on the globalforeignexchangemarkets.

Themostimportantcentralbanksare:

⇒USFederalReserveSystem

⇒EuropeanCentralBank

⇒BankofJapan

⇒BankofEngland

⇒ReserveBankofAustralia

⇒SwissNationalBank

⇒BankofCanada.

USFederalReserveSystemCreatedin1913undertheFederalReserveAct,themandateoftheUSFederalReserveSystem(alsoknownastheFed)includesmaintainingthestabilityofthecountry’s financial system, conducting monetary policy, and achieving pricestability and long-term economic growth for US citizens. It comprises achairperson and board of governors appointed by the US president, thepresidentsof12regionalFederalReserveBanksandrepresentativesfromotherprivateUSmemberbanks.TheFederalOpenMarketCommittee(FOMC)isthegroupwithintheFedthatmakesinterestratedecisions.

TipTheUSFederalReserveSystemisstillthemostinfluentialcentralbankintheworld,anddecisionsmadebytheFederalReserveBoardhaveasignificantimpactonglobalfinancialmarkets.

Themakeupof theUSFederalReserveSystemisuniqueamongcentralbanksbecause it is partly a public and partly a privately run institution and, unlikeother central banks, it is not directly responsible for the creation of the UScurrency.Thisoftengivesrisetodebateastojusthowindependent theFedis,and towhom it owes its strongest allegiances— theAmerican people, or thebankingsystem.

EuropeanCentralBankEstablished in 1998 by the Treaty ofAmsterdam, the European Central Bank(ECB)administersthemonetarypolicyofthe16Eurozonememberstates.ThemandateoftheECBispricestability,long-termeconomicgrowthandanannualinflation target of less than 2 per cent. Other key areas of activity includeconducting foreign exchange operations to manage the foreign exchangereserves of the national banks of the EUmember states, and monitoring andmaintainingtheEurozonebankingsector.

The Governing Council is the main decision-making body of the ECB. Itcomprises the sixmembers of the Executive Board, and the governors of thenational banks of the 16 Eurozone members. The ECB is an independentorganisation within the EU, effectively managing the monetary policy formember states. It is known to provide markets with ample warning of anyimpendingpolicychanges.

BankofJapanTheBank of Japan (BoJ) has operated continuously since its establishment in1882, though ithashadanumberofpolicy revisionsand reorganisationsoverthe years. Its current mandate includes currency and monetary control, pricestability and the development of the national economy. Because Japan has anexport-driveneconomy,theBankofJapanhasaninterestinpreventingastrongJapanese yen, because a high-value currency has a negative effect on Japan’sexportbusinesses.TheBankof Japanhasbeenknown todirectly intervene inthecurrencymarkettoweakentheyenbysellingitagainsttheUSdollarandtheeurowhenitisconcernedabouttherelativevalueoftheyen.

ThePolicyBoard,whichincludesthegovernor,twodeputygovernors,andsixother board members, is responsible for all major policy decisions. Althoughcooperationwiththegovernmentisexpected,theBankofJapanoperatesasanindependentcentralbank.Governmentofficialscanattendboardmeetings,butonlyinanon-votingcapacity.

BankofEnglandTheoriginsoftheBankofEngland(BoE)canbetracedbackto1694,thoughitsrole has changed over the last 300 years. It is the central bank for thewholeUnitedKingdomand is themodeluponwhichmostmodern central banks arebased.Itwasprivatelyownedandoperateduntilitwasnationalisedin1946,andbecameanindependentpublicorganisationin1997,whenitwasgivenstatutoryauthority for setting the interest rates in the United Kingdom. Its two corepurposes are monetary stability and financial stability, and it maintains aninflationtargetof2percentperyear,similartothatoftheECB.

The Bank of England ismanaged by a court of directors, all of whom areappointed by the government, and which includes a governor, two deputygovernors and nine non-executive directors. It has a nine-member monetarypolicy committee consisting of the governor, two deputy governors, twoexecutivedirectorsandfourexternaladvisers.

TheBankofEnglandhad a difficult period during the 1990swhen, despitedoubledigitinflation,BritainagreedtojointheEU’sexchangeratemechanism.TheBoEwasabletokeeptheBritishpoundwithinthe6percentrangeallowedunder the ERM for a short period. Eventually, however, the pressure of theartificiallyhighinterestratesrequiredtomaintainthepound’svalueagainsttheGermanmarkandaweakdomesticeconomy,combinedwithahugespeculativeshortsalebyGeorgeSoros’shedgefund,createdtheeventsofBlackWednesdayinSeptember1992.

ReserveBankofAustraliaTheReserveBankAct1959establishedtheReserveBankofAustralia(RBA)astheAustralia’s central bank.Like all themajor central banks, theRBAcarriesout open market operations, transactions in foreign exchange markets, andmonetarypolicyoperationsinordertomeetitsmandateofastablecurrency,themaintenanceoffullemployment,andeconomicprosperityandwelfareinalow-inflationenvironmentofbetween2and3percent.

TheRBAhastwoboards: theReserveBankBoard,whichisresponsibleformonetarypolicyandfinancialstability,andthePaymentsSystemBoard,whichisresponsibleforthecreditandpaymentsystems.TheReserveBankBoardhasnine members: the governor, who is appointed by the federal governmenttreasurer,adeputygovernor,thesecretarytothetreasurer,andsixnon-executiveexternalmembers,whoarealsoappointedbythegovernment.Membersof theRBA board must not be a director, officer or employee of any authoriseddepositoryinstitution.

TipThe complex nature of theAustralian economy in the commodity cycle, the inverse relationship of theAustraliandollartotheothermajorcurrencies,andtheboomandbustnatureoftheAustralianeconomyprovidecontinuingchallengesfortheRBA.Itoftenstrugglestogetmonetarypolicytimingdecisionstolineupwithwhatisreallyhappeningintheeconomy.

SwissNationalBankThe central bank of theSwissConfederation, theSwissNationalBank (SNB)commenced operations in 1907. It is an independent central bank with theprimarygoalsofpricestability(aninflationrateof2percentperannumorless)andeconomicgrowthinthebestinterestsofthecountry.

TheSNBhas a two-tieredgoverning structure—an11-memberGoverningCouncil, with six government-appointed members and five elected members,and a three-member Governing Board comprising the chairperson, vicechairperson, and one other member, all appointed by the government. TheGoverning Board has complete responsibility formonetary policy and overallstrategicplanning.

The Swiss National Bank uses open market operations and facilities toinfluence interest rates and to implement its monetary policy. Unlike othercentral banks it sets a target range for a reference interest rate rather than aspecificdefinedrate.Italsoreliesentirelyonopenmarketoperationstomanagethe value of theSwiss franc on currencymarkets.Aswell as the use of openmarketrepotransactionstoaffectcurrencyliquidity,theSNBalsomandatestheamountofcurrencythatcommercialbanksmustholdasreserves.Thesemustbeheld as Swiss franc banknotes, coins, or sight deposits (funds that can betransferredbetweenvariousaccountsandcanbequicklyconvertedtocash)heldattheSNB.Thisreserverequirementiscurrentlysetat2.5percent,butcanbeincreasedtoamaximumof4percentifnecessary.TheSNBalsomanagestheofficialgoldreserves,whichareusedtobackthecurrency.

BankofCanadaCreatedbytheBankofCanadaActof1934,theBankofCanada’sprincipalroleis the economic and financialwelfareof theCanadianpeople.Like all centralbanks,itsmandateincludesensuringlowandstableinflation,financialsecurityandcurrencymanagement.Ithasaspecificaimtokeepinflationmaintainedatbetween1and3percent.

TheGoverningCouncilisresponsibleforallmonetarypolicydecisions.Thiscouncil comprises the governor of the Bank of Canada, the senior deputygovernor,andfourdeputygovernors,whoareappointedbythebank’sboardofdirectors.Thedeputyministerof financesitson theboardbutdoesnothaveavote.

TipTheBankofCanadafavourstheuseofinterestratesasitsinflationarycontrolmechanism.Since1998thebankhasmaintainedapolicyofnotinterveningintheforeignexchangemarket,exceptunderexceptionalcircumstances, preferring instead that the value of the Canadian dollar be determined by supply anddemandforthecurrency.

Chaptersummary

⇒Althoughallcountrieshavetheirowncurrency,foreignexchangetradingislimitedtothecurrenciesthathaveaglobalpresencethroughtheiruseininternationaltradeandinvestment.

⇒TheUnitedStatesdollar(USD,$)effectivelybecametheworld’sreservecurrencyundertheBrettonWoodsAccord.AsaresulttheUSdollarremainstheworld’smaincurrencywithmostglobaltradeoutsideofEuropestillbeingquotedinUSdollars.

⇒OfmajorinterestinthefuturewillbewhethertheChineseyuanbecomesafree-floatingcurrencyandcanbefreelytradedonforexmarketslikeotheropenmarketcurrencies.

⇒Sincetheintroductionoftheeuroin1999,theimportanceoftheUSdollarasaninternationalreservecurrencyhasdeclined.TheUSdollarisstillthemost-heldreservecurrency,withholdingsstillmorethandoublethatoftheeuro,buttheimportanceoftheeuroissteadilyincreasing.

⇒DespiteamuchsmallerinternationalpresencethaneithertheUSdollarortheeuro,theJapaneseyenisthethirdmosttradedcurrencyintheworld.

⇒TheBritishpoundwassubjecttooneofthemostaggressiveattacksonthevalueofacurrencyinSeptember1992byalargehedgefund,whichwasconvincedthatthepoundwasovervalued.

⇒BoththeAustraliandollarandCanadiandollararereferredtoascommoditycurrenciesbecauseoftherelianceofthesetwoeconomiesonrawmaterials.

⇒TheSwissfrancisstillbackedbya20percentgoldreserve.

⇒Acentralorreservebankisthefinancialinstitutionthatoverseestheoperationofthebankingandmonetarysystemwithinacountry.

⇒Monetarypolicyisthemaintoolcentralbanksusetocontrolinterestratesandcurrencyvalues.

⇒Themandateofallthecentralbanksisverysimilar,withafocusonlowinflation,currencystability,economicgrowthandprosperitywithinaneconomy.

Chapter3:Theforeignexchangemarketsandmajorparticipants

Nowthatwehaveaninsightintothemajorcurrenciesandtheireconomies,andthe important role that central banks playwithin an economy and the foreignexchange,or forex,markets,wenowneed todeepenourunderstandingof theforexmarketbeforewebeginforextrading.

We need to understandwho themajor players in thesemarkets are and thetypesofforexmarketsavailable.

ForexmarketparticipantsAswellasthecentralbanksandtheirroleinandinfluenceontheglobalforeignexchangemarket,manyotherparticipantsareinvolvedinthetradingofforeignexchange.Itisimportanttoknowwhotheseotherplayersare,wheretheyfitinthemarketandtherolestheyplaywithintheforeignexchangemarket.TipTheforeignexchange,orforex,marketisdividedintolevelsofaccessthataredeterminedbythesizeoftheline,oramountofmoney,beingtradedineachtransaction.

Theinter-bankmarketAfter the central banks, the large global commercial banks and financialinstitutionsarethemajorparticipantsintheforexmarket,andtogethertheyformthe inter-bank market. While central bank operations in the market may besporadic,thelargecommercialbanksareactivelyinvolvedinforeignexchangetradingeveryday.Their tradingactivitiesaddmassive liquidityandvolume tothe market daily and are the main cause of price movement in the markets.Major international banks deal either directly with each other or through twomain electronic platforms, EBS andReuters,which offer trading in themajorcurrencypairs.Thebanksregularlyundertaketradesworthbillionsofdollarsonbehalfofclientsor,morecommonly,speculateingontheirownaccounts.They

areresponsibleforthemajorityofforextradingvolume.

The inter-bankmarket is anunregulatedanddecentralisedwholesalemarketthatworksaroundtheworldandaroundtheclock.Thesebankseffectivelyactasmarketmakersinthespotforexmarket(discussedlaterinthischapter),astheyare constantly quoting buy and sell prices in anticipation of movements incurrencyprices.TipTheforexpricequotesweseeonourtradingplatformsaretheresultofthetransactionsbetweenthelargebanksandfinancialinstitutionsintheinter-bankmarket.Theiractivitytendstosetthebuyandsellquotesthatarethenmadeavailabletoretailbrokersandtraders.

CompaniesandbusinessesMultinationalcompaniesareoftenparticipantsintheforexmarkets,conductingtransactions related to the purchase or sale of goods and rawmaterials, or theconversionofoverseasearningsintothecompany’sdomesticcurrency.Muchoftheir activity involves hedging against adverse currencymovements to protecttheir overseas and import and export operations, or to lock in favourableexchange rates. However, many also speculate in the currency markets. Theactivitiesoftheselargecompaniesaddfurtherliquidityandvolatilitytotheforexmarkets.Theyoftenhavelargerpositions,unknowntoothermarketparticipants,whichtheyimplementorcoverquicklyandunexpectedly,resultinginsharpandsuddenpricemoves.

HedgefundsLargehedgefundsthattradeinallmarketsforspeculativepurposestogenerateabove average returns for their investors are also participants in the foreignexchangemarket.They speculate aggressively and can take large positions byusingtheleverageofferedintheforexmarkets.(Leverageisexplainedindetailinchapter5.)Perhaps themost famousexampleofhedgefund involvement inthecurrencymarketsisthe1992attackontheBritishpoundbyGeorgeSoros’shedge fund as discussed in chapter 2.Most hedge funds, however, tend to betrend followers, building into positions over time and capturing large pricemovements.Tip

Hedgefundsareunregulatedprivate investmentcompanies thatusehigh-riskstrategies todramaticallyincreasereturnstotheinvestorsinvolved.

As price speculators, hedge funds are interested only in profiting from pricemovements incurrencieseitherbybeing longinamarket trendingupwardsorshortinadown-trendingmarket.

InvestmentmanagementfirmsThese firms manage large accounts on behalf of pension and superannuationfunds,andtheyoftenhaveinternationalshareportfoliosandotherinternationalinvestments. They use the currencymarkets to buy and sell currencies in linewith their international investment transactions and to hedge currency risksassociated with their international share and property holdings. They are notinvolvedinthecurrencymarketsforspeculativepurposes.

RetailforeignexchangebrokersandtradersThedevelopmentoftheinternetandtheadventofonlinetradingplatformshasrevolutionised trading for retail and private traders across all markets. In theforexmarketthelargebankswerenotsetuptoservicetheneedsofretailplayerstradingwithsmallamountsofcapitalbutwhostillwantedtotakeadvantageoftheopportunitiesofferedbytradingthecurrencymarkets.ThisinitiallyledtotheformationoftheInternationalMoneyMarket(IMM)forthetradingofcurrencyfutures, and then to the use of the spot forexmarket by retail traders throughonlinebrokingcompanies that canprovideaccess to the inter-bankmarket forsmaller retail clients. The high liquidity and 24-hour availability of the forexmarketmakeitparticularlyappealingtospeculatorswantingtoachieveareturnontheircapitalbybuyingandsellingcurrencies.

Retail and small traders provide liquidity and price discovery (thedetermination of price through the interaction of buyers and sellers) to themarket,makingiteasierforhedgersandothermarketparticipantstooffsettheirrisk.Retailandsmalltradersarethelargestsectionbynumberwithintheoverallforexmarket,executingmillionsofindependenttradeseveryday.Althoughthevalue of these trades is small compared with the trading activities of thecommercialbanksandotherlargetraders,werepresentagrowingandimportant

componentofthecurrencymarkets.TipAs risk seekers seeking to make profits from their buying and selling activities, speculators play animportantrolewithinanymarketplace.

VariouscurrencymarketsTradingcurrenciesisconductedinoneofthreeways,through:

1forwardsandswapsmarket

2currencyfutures

3spotforexorretailforexmarket.

While most of the hype in the forex space is concerned with the spot forexmarket,currencyfuturescontractsarealsoahighlyliquidandtradeableproductthatshouldbeconsideredasaviabletradingvehicle.Thevastmajorityofretailforex traderswill never use forwards or swaps, but some readers of this bookinvolvedininternationalbusiness transactionsmayusethem.It is important tounderstandwhattheyareandhowtheyareusedtobuildadeeperunderstandingoftheroletheyplayinforexpricingandliquidity.Let’stakealookateachoftheseforexproductsandwheretheyfitintheoverallforexmarket,andhowtheyaddsignificantvolumeandliquidity to theforeignexchangemarkets.Awholebookcouldbewritten about eachof theseproducts and the intricateworkingsand inter relationships between them.What follows is an introduction to, andbriefoverviewof,each.

TheforwardsandswapmarketThismarketconsistsoftwomaininstruments—forwarddealsandswaps.TipThe forward currencymarket is usedmostly by large institutions and companies for both hedging andspeculating.

Forwardoutrightsorcurrencyforwardcontracts

Referred to simply as forwards, these consist of a non-standardised contract

betweentwopartiestobuyorsellaspecifiedamountofacurrencyatanagreedexchangerate(calledthedeliveryprice)atanagreedfuturedate.Theseforwarddatesarenormallybetweentwodaysand24monthsfromthecurrentdate.Thetermsof the contract are agreeddirectlybetween the twoparties involvedandthetradedoesnottakeplaceonaregulatedexchange.Asaresult,anycurrencycan be used, provided both parties agree on the terms and conditions of thetransaction.

Thepriceof the forward is basedon the existing exchange rateon the spotmarketatthetimethedealisagreed,plusanadjustmentfactor,whichrepresentstheinterestratedifferentialbetweenthetwocurrencies.Theseareknownastheforward points, and they can be set either at a discount or a premium to thecurrent spot rate, dependingonwhat theparties involvedbelieve interest ratesandthuscurrencyexchangerateswilldobetweenthecurrentdateandthedateon which the forward matures. The forward outright rate is determined byadjustingthecurrentspotratebythediscountorpremiumpoints.

Thepartyagreeingtobuythecurrencyassumesalongposition,andthepartyagreeing to sell the currency assumes a short position.A forwardmay have aspecifiedmaturity date or itmaymaturewithin a specifieddatewindow.Thiswindowisaspecifiedperiodwithinwhichthecontractcanbeexercisedbythebuyer, and it may vary from a week to one month, depending on the termsagreedbythetwoparties.TipForward outrights can be used for speculating on interest rate and currencymovements, but they aregenerallyused tohedge foreign exchange exposure risksor to stabilise future cash flowsbasedon thecurrentexchangerate.

Tradinginforwardoutrightsforspeculativepurposesisacomplexoperationthataimstotakeadvantageofinterestratedifferentialsbetweentwocurrencies,withthe trader effectively speculating onmovements in four different rates.Whentrading theAustralian dollar/US dollar (AUD/USD) as a forward outright, forexample, thefourvariables thatcandetermineif the tradermakesaprofitoraloss are changes in Australian interest rates, changes in US interest rates,movements in theAUD/USDspotrate,andchangesin theAUD/USDforwardrate.

Forwardsaremorecommonlyusedbythoseseekingtohedgethevalueofa

currency. Companies trading internationally can experience volatility in theirforeignexchangeexposurethatcanincreaseriskanduncertaintyintheexpectedprofit.Forwardsallowcompaniestolockinforeigncurrencytransactionsforafuturedateatarateagreedtonow.Theneteffectistoneutraliseanyexchangeratefluctuations.

An importer may, for example, have ordered goods from a supplier in theUnited States. They make one payment when the goods are ordered, with asecondpaymentdue in fourmonths’ timewhen thegoodsaredispatched.Thefirst payment is made immediately at the prevailing exchange rate of 0.9850AUD/USD,andtheimporterwantstolockinthisexchangerateforthesecondpayment.Thecurrentorspot ratehas tobeadjustedfor theforwardpoints forthefour-monthperiodtothesecondpayment.Thisfigureisagreedatapremiumof 0.0045, making the forward rate 0.9895 (the spot rate of 0.9850 plus the0.0045forwardpoints=0.9895).The importernowknowstheexactexchangerate they will pay in four months’ time and it is not exposed to any adverseexchange rate movements. They have hedged their exposure and risk. Thedownsideis,ofcourse,thattheyhavegivenupthepotentialtoprofitfromanyfavourableexchangeratemovements.

Forwardsarealsousedbyinternationalportfoliomanagersinmuchthesameway,allowingthemtolockinexchangeratesforinternationaldeals.Commercialbanksalsouseforwardsforliquidityandriskmanagement,andforspeculativepurposes.

Forwardoutrightsarenegotiatedoverthecounter(OTC)betweenthepartiesinvolved.As a result they are non-standardised in termsof their contract size,settlementdateandprice,providingahighdegreeofflexibilityforusersoftheseproducts. One of the major downsides is that both parties involved in thetransaction are exposed to the credit risk associated with the possibility thateitherpartymaydefaultonthedeal.

Non-deliverableforwards

A non-deliverable forward (NDF) is a short-term, cash-settled currencytransactionbetweentwocounterparties.AnNDFissimilartoaforwardoutright,exceptthatnophysicaldeliveryoftheprincipalornotionalamounttakesplace.Onthecontractsettlementdateonlythedifferencebetweentheforwardagreed

rateandtheprevailingspotrateisexchangedaseitheraprofitoralossincash.BecauseNDFsarenon-cash,off-balancesheet transactionswhere theprincipalsumsdonotactuallychangehands,theyoffermuchlowercounterpartyriskthanforwardoutrights.

NDFsaretypicallyquotedandsettledinUSdollars.AllNDFshaveafixingdate,whichisthedatetheagreementismadeandtheexchangeratecalculated,and a settlement date, which is the due date for the payment of the cashdifference.

TheNDFmarkethasevolvedasaresultofrestrictionsinsomecountriesoncurrencyexchangemovements.NDFsallowthehedgingofcurrenciesthatcouldnot otherwise be hedged because of these restrictions. NDFs are used bycompaniesseekingtohedgetheirexposuretonon-convertibleforeigncurrency,such as the Korean won and other emerging market currencies, where thecompanies’businessactivitiescreateforeignexchangeexposure.TipNDFsarealsousedbybanksandotherlargespeculatorsseekingtoprofitfrommovesintheinterestratesandexchangeratesofcurrencieswhereaspotmarketisunavailable,andwhereexpectedoranticipatedregulatorychangeswillaffecttheexchangerate.

NDFscanalsobeusedtocreateasyntheticcurrencyloaninacurrencythatmayfaceliquidityandotherissues.Forexample,adomesticcorporationinacountryfacedwithcurrencymarketlimitationsmayneedtoborrowUSdollarstopayasupplier,but it has tomake repayments in the local currency.Under the termsagreedintheNDF,theborrowerreceivestheUSdollarsumfromthelenderandrepayments are calculated inUS dollars, butmade in the local currency at anagreed exchange rate. The lender enters into anNDF agreementwith anotherparty that matches the cash flow from the original deal based on the foreigncurrencyrepayments.TheborrowerhasmettheirneedforaloaninUSdollars;thelenderhascreatedasyntheticdollarloan;andthecounterpartyhasanNDFcontractwiththelender.TipThese complex deals are usually undertaken for large amounts between governments, large financialinstitutions,andmultinationalcorporationswithglobaloperationsandriskexposure.

Swaps

Currency swaps originated in the United Kingdom in the 1970s, when UKcompanieswereforcedtopayapremiumtoborrowUSdollars,so theysetupback-to-backloanswithUScompaniesthatneededtoborrowBritishpounds.

Currencyswapsarethesimultaneouspurchaseandsaleof identicalamountsof one currency for another with different value dates. They allow the twopartiesinvolvedintheswaptoexchangeaspectsofaloaninonecurrency(theprincipalandinterestpayments)forequivalentaspectsinanothercurrency.

Swapscanbestraightforwardcurrencyswaps,whereonecurrencyissimplyswapped for another currency and then the swap reversed at an agreed futuredate; they can combine the currency exchange with interest rate and otherpayments; or they may involve swapping only the interest rate payments onloans of the same size and maturity date. They generally involve a spottransaction combined with a forward outright transaction. Commercial swapsmakeuseofcomparativeadvantagewhereadomesticborrowermaybeabletosecureamorefavourableinterestratethananoverseasborrower.Thedomesticborrower can then swap the principle, or the repayments, or a combination ofboth, with an offshore party for a similar deal in another currency, offeringbenefitsforbothparties.TipSwapsareusedbylargecommercialbanksandcentralbankstofundtheirforeignexchangebalancesandtoensuretheyhaveaccesstowidelyusedcurrenciesasandwhentheyneedthem.Commercialbanksuseswaps if they need to exchange currencies with other banks or if a client needs a large amount of acurrency.

Central banks use swaps to maintain liquidity during times of economicdifficulty,suchasduringtheglobalfinancialcrisis.TheaimoftheseswapsistomaintainliquidityinUSdollarsintheglobalbankingsystem.Thecentralbanksswap currencies according to their need tomake emergency loans using theirdomesticcurrency.Inthissituationtheyareabletoswaptheirforeigncurrencyreserves of, say, US dollars with the US Federal Reserve Bank’s reserves ofothercurrencies.

Largemultinationalcorporationsalsouseswapstosecurecheaperfundingorto hedge against exchange rate fluctuations. Cheaper debt funding uses thecomparative advantage function described above whereby a local institutionborrows funds at thebest available rate and then swaps thedebt in aback-to-

backloanwithanoffshorecompany.

A currency hedge can also be put in place to reduce exposure to foreignexchange fluctuations by using a swap in one of two ways. Let’s say anAustralian-basedcompanyneedstoborroweuros,andaFrenchcompanyneedsto borrow the same amount in Australian dollars. If the two companies havealreadyborrowed the funds in thecountrywhere theyare required, theycouldarrangeaswapofcashflowssothateachcompany’sborrowingcostisnowintheir domestic currency. Alternatively, they could arrange the loans in theirdomesticcurrencies(perhapswithacomparativeadvantageinregardtointerestrates)andthenarrangeaprincipalswapintothecurrencytheyneed.TipSwaps are an over-the-counter product like forwards, so they can be arranged according to therequirementsofthepartiesconcernedandareagreedaccordingtotheseneeds.Amounts,repaymentdatesandallothercomponentsofthecontractareflexibleandcanbenegotiatedbetweenthepartiesinvolved.

CurrencyfuturesAfuturescontract isa legallybinding,standardisedagreement tobuyorsellastandardisedcommodityorfinancialinstrumentofspecificqualityandquantityonaspecifiedfuturedeliverydateatagivenlocation.Theonlyvariableisprice.

Futures contracts are based on an underlying, tangible commodity, such aswheatorleanhogs,oranindex,suchastheS&P500,or,inAustralia,thesharepriceindex(SPI).Somefuturescontracts,suchaswheatandlivecattle,callforphysical delivery, while others, such as S&P 500 and SPI contracts, are cashsettled. Futures contracts are traded on a regulated exchange. As a derivativeproduct, like all futures contracts, currency futures are traded using leverage,allowingasmallamountofcapitaltocontrolamuchlargerposition.

Similarly, currency futures are futures contracts where the underlyingcommodity is an exchange rate, such as the Australian dollar to US dollarexchange rate. A currency futures contract is a contract to exchange onecurrencyforanotherataspecifiedfuturedateatanexchangeratethatisfixedonthedateofthetransaction.Currencyfuturesaretradedinpairs,withthevalueofone currency quoted against the value of another. Like all futures contracts,currencyfuturesarestandardisedcontracts, tradedonanexchange,andalwayscashsettled,asonecurrencyamountisalwaysexchangedforanother.

TipCurrency futures were introduced by the ChicagoMercantile Exchange (CME) in 1972 following thecollapseof theBrettonWoodsAccordand the introductionof free-floatingcurrencies,because traders,investorsandbrokerswerefrustratedbythelackofaccesstotheinter-bankmarketforcurrencytrading.

Traders at theCME established the InternationalMoneyMarket (IMM) as analternative to the inter-bank market and launched trading in seven currencyfutures,creatingamarketforstandardisedfuturescontractswithamatchingandclearingserviceforthepromptexecutionofalltrades.TheIMMoperatestodayas a division of the CME, offering futures contracts in 19 currency pairs,including two e-mini contracts and six e-micro contracts, which are smallerversionsofthestandardfuturescontracts.CurrencyfuturesarealsotradedontheNew York Stock Exchange (NYSE), the Euronext Exchange in London, theTokyoFinancialExchangeandtheIntercontinentalExchange(ICE)basedintheUS.

Currencyfuturescontractspecifications

Likeall futurescontracts, currency futureshavestandardisedcontractsandaretraded on a registered exchange. Each contract has detailed specifications,includingwhereandwhenthecontractcanbe traded, thefacevalueorsizeofthecontract,thesmallestincrementalpricepointthatcanbetraded,thedateofexpiry of the contract, and the margin requirements. Figure 3.1 shows thecontract specifications for the New Zealand dollar currency futures contracttradedontheCME.

Tradingonaregisteredexchangemeansthatthereisnocounterpartyriskforeitherpartyinvolvedinafuturestransaction.Unlikeover-the-countercontracts,suchasforwardsandswaps,wherethereistheriskthateitherpartytothedealmaydefault, the riskofdefaultwith futurescontracts isvirtuallyzerobecausethe buyer and the seller do not deal directly with each other. Instead, theexchangeclearinghouseguaranteesboth sidesof the transaction.Theclearinghouse achieves this by charging traders an initial margin and a maintenancemargin on each futures contract. The operation of a centralised exchange isshowninfigure3.2.

Contractpricesforfuturesaredeterminedbytheinterestrateforthecurrencypair that constitutes the futurescontract, aswell as theprevailing spot rate foreach currency. This means that any arbitrage differences between the futures

marketandthespotmarketareeliminated,asthecontractpricemovesintandemwithfluctuationsinthespotrate.Thefollowingformulaisusedtosetthepriceforacontractforagivencurrencypair:

Figure3.1:contractspecificationsforNewZealanddollarfutures

Source:CMEGroup.

Figure3.2:howacentralisedmarketworks

TipPricearbitragecanoccurwhenthesamecurrencyislistedonmorethanoneexchangeatthesametime.If thepricechangeononeexchangelagsbehindtheotherthenanopportunityarisestoprofit fromthedifferenceinpricebetweenthetwoexchanges.If,forexample,thevalueoftheAustraliandollarroseonthespotmarket,butthiswasnotreflectedinthefuturesmarket,thenanarbitrageopportunitywouldexist.If the futuresmarket pricewere seen to be lagging, then theoretically it would be possible to buy theAustraliandollarfuturescontractinanticipationofit‘catchingup’tothepriceinthespotmarket.

Currencyfuturesareusedbybothhedgersandspeculators.Importers,exportersand international banks use currency futures to hedge and reduce currencyexchangerateexposure.Theseorganisationsmayhaveaforwardpaymentdue,orbeexpectingapaymentinthefuture,andtheycanlockintheexchangeratebeforetheduedatethroughtheuseofcurrencyfutures.Tradersseekingtoprofitfrom exchange rate movements are also active participants in the currencyfuturesmarkets.Theyareattractedtotheuseofcurrencyfuturesbytheleverageoffered,theliquidityavailableandtheabilitytotradebothlongandshortinthecurrencyfuturesmarket.

The mechanics of trading currency futures will be discussed in detail inchapter4.

ThespotmarketThe spot foreign exchange market is an inter-bank or inter-dealer electronic,over-the-counter (OTC)network linkingcurrency tradersaround theglobeandaround the clock. As an OTCmarket, transactions do not occur on a centralexchangeliketheCMEfuturesexchangeortheAustralianSecuritiesExchange(ASX),butinsteadaremadeelectronicallybetweenthetwopartiesinvolvedinthe transaction. Originally the domain of the large banks and other financialinstitutions who traded with each other and with other credit-approvedinstitutions,thearrivaloftheinternetandthedevelopmentofbrokeranddealeronline tradingplatformshas facilitated the tradingof forexby retail clientsby

computer. Retail traders are now able to trade in the forex inter-bankmarketthroughtheirchosenbrokerordealerplatform.Theoperationofthespotmarketisshowninfigure3.3.

Thespotmarketisalsoreferredtoastheforeignexchangemarket,FX,forex,spotFX,marginFXandretailFX—regardlessoftheterm,thespotmarketissimply the tradingofonecurrencyagainst thevalueofanother.Currenciesarealwaystradedaspairs,withpricesbasedonthespreadbetweenthesetwopricesbeingestablishedbytheparticipantsinthemarket.

Figure3.3:howthedecentralisedspotforexmarketworks

Theoriginalpurposeofthespotforexmarketwastosupportinternationaltradeand investment by allowing commercial banks and businesses tradinginternationallytoconvertonecurrencytoanother.Thespotmarketisnowalsothe largest speculative market in the world, and the world’s most liquid andaccessible cash market. The spot market is the first step in all internationalcurrencyflows,asdealscanbedonewithinsecondsasexchangerateschangeinlinewithinterestrateandothereconomicannouncements,geo-politicalevents,andawidevarietyofotherfactors.Thespotmarketcanbeseenastheworld’slasttrulyfreemarket.TipAspotforeignexchangetransactioninvolvesthepurchaseofonecurrencyagainstthesaleofanotheratthecurrentmarketrateforsettlementintwodays’time.Itiseffectivelythepurchaseofonecurrencybyborrowinganother.

Currency transactions that require same-day settlement are called cashtransactions. The two-day delivery period for spot currency transactions wasoriginally developed long before the information technology systemswe nowhavewereavailable.Twodayswasseenasareasonabletimeforbothsidesof

the transaction to check all the details, rectify anymistakes and then arrangesettlement.Ifastandardspotdealisnotsettledwithintwodays,interestaccruesagainstthepartythathasfailedtodeliver—thisisknownasrolloverorroll.Inthe retail forex market, open positions (any trades that you have open) areautomaticallyrolledoverbyyourbrokertothenextsettlementday.Youmaybechargedorpaidinterestdependingonyouropenposition.Thisprocessformsthebasisofthecarrytrade,whichwillbediscussedinchapter6.TipThe spot forex market originated in 1971, when many of the major world currencies began movingtowardsfree-floatingexchangerates.Thespotmarketisthereforeconsideredtheoldestforeignexchangemarket, and it represents the underlyingmarket for all foreign exchange–related derivatives, includingcurrencyfutures,forwards,swapsandoptions.

Combined average daily turnover in all OTC forex-related instruments wasestimatedbytheBankofInternationalSettlements(BIS)TriennialCentralBankSurvey inApril of 2010 tobeUS$3.98 trillion.This is a 20per cent increaseovertheUS$3.32trillionestimatedaveragedailyturnoverreportedinthesamesurveyinApril2007.Thisdailyturnoverisbrokendownasfollows:

⇒US$1.490trillioninforeignexchangespottransactions

⇒US$475billioninforwardcontracts

⇒US$1.765trillioninforexswaptransactions(principalonly)

⇒US$43billionincurrencyswaps(interestonly)

⇒US$207billioninoptionsandotherproducts.

Turnover in the spotmarket increasedby approximately48per cent from justoverUS$1trillionperdayintheApril2007surveytoUS$1.49trillionbyApril2010. The spot market now accounts for 37 per cent of OTC daily foreignexchangeturnover,justbehindtheswapsmarket,whichaccountsfor45percentoftheaveragedailyOTCforeignexchangeturnover.TheaveragedailyturnoverintheOTCswapsmarketincreasedbyjustunder4percentoverthesamethree-yearperiod.These figureshighlight the enormousgrowth that hasoccurred inthespotforexmarket.

Thegrowthintheglobalforeignexchangemarketand,inparticular,thespotmarketsince1998isshownintable3.1(overleaf).Alsoofinterestisthegrowth

in theaveragedaily turnoverofexchange-tradedderivatives (currency futures)overthisperiod.FromarelativelysmallUS$11billionperdayin1998,turnoverhasgrowntoUS$166billionperdayin2010.Inthethree-yearperiodfrom2007to 2010, average daily turnover in currency futures increased by over 107percent.

Table3.1:averagedailyglobalforeignexchangemarketturnoverinApril,1998to2010,inbillionsofUSdollars

Source:BankofInternationalSettlementsTriennialCentralBankSurvey,April2010.

Thegeographicalspreadoftradersparticipatinginthespotmarkethasledtotheemergenceofmajor tradingcentrescoveringthemajorworldtimezones,eventhoughforeignexchangecanbetraded24hoursadayforfiveandahalfdaysper week, starting in New Zealand on Monday morning (Sydney time) andfinishingwiththecloseoftheNewYorkmarketearlySaturdaymorningSydneytime.According to theBISTriennial Study in 2010, banks located in theUKaccountedforalmost37percentofaveragedailyturnover.ThiswasfollowedbytheUSwith 18 per cent; Japan, 6 per cent; Singapore, Switzerland andHongKong, 5 per cent each; and Australia, 4 per cent. Since London is the majorforeignexchangemarket,mostonlinetradingplatformstendtousethebuyandsellpricesbeingquotedinLondon.

Chaptersummary

⇒Aswellasthecentralbanks,whichhavearoleinandinfluenceontheglobalforeignexchangemarket,manyotherparticipantsareinvolvedintradingforeignexchange.

⇒Majorinternationalbanksdealeitherdirectlywitheachotherorthroughtwomainelectronicplatforms,EBSandReuters,whichoffertradinginthemajorcurrencypairs.

⇒Theinter-bankmarketisawholesalemarketthatisunregulatedanddecentralised,anditoperatesaroundtheworldandaroundtheclock.

⇒Muchoftheactivityoflargemultinationalcompaniesintheforeignexchangemarketinvolveshedgingagainstadversecurrencymovementstoprotecttheiroverseasandimportandexportoperations,orlockinginfavourableexchangerates,thoughmanyalsospeculateinthecurrencymarkets.

⇒Hedgefundsarebecomingincreasinglyinvolvedintheforeignexchangemarket,attractedbytheleverageitofferstoincreasereturnsontheirfundsundermanagement.

⇒Thedevelopmentoftheinternetandtheadventofonlinetradingplatformshaverevolutionisedtradingforretailandprivatetradersininvestorsacrossallmarkets.

⇒Retailandsmalltradersprovideliquidityandpricediscoverytothemarket,makingiteasierforhedgersandarbitrageurstooffsettheirrisk.Retailandsmalltradersarethelargestsectionbynumberwithintheoverallforeignexchangemarket.

⇒Forwardsareanon-standardisedcontractbetweentwopartiestobuyorsellaspecifiedamountofacurrencyatanagreedexchangerate(calledthedeliveryprice)atanagreedfuturedate.

⇒Anon-deliverableforward(NDF)issimilartoaforwardoutright,exceptthatnophysicaldeliveryoftheprincipalornotionalamounttakesplace.

Onlythedifferencebetweenthetwopricesisexchangedincash.

⇒Currencyswapsarethesimultaneouspurchaseandsaleofidenticalamountsofonecurrencyforanotherwithdifferentvaluedates.

⇒Currencyfuturesarefuturescontractswheretheunderlyingcommodityisanexchangerate,suchastheAustraliandollartoUSdollarexchangerate.

⇒Thespotmarketisalsoreferredtoastheforeignexchangemarket,FX,forex,spotFX,marginFXandretailFX.Regardlessoftheterm,thespotmarketissimplythetradingofonecurrencyagainstthevalueofanother.

⇒Theoriginalpurposeofthespotforexmarketwastoencourageinternationaltradeandinvestmentbyallowingcommercialbanksandbusinessestradinginternationallytoconvertonecurrencytoanother.Spotforexisnowalsothelargestspeculativemarketintheworld,andtheworld’smostliquidandaccessiblecashmarket.

Chapter4:Retailforexdealersandmarketmakers

Thespotforexmarkethasopeneduptoretailtraderslikeussincetheinceptionof the internet and the development of online broker trading platforms. Theseprovide access to the currencies and prices traded on the inter-bank marketthroughanetworkofdealersandmarketmakers.Beforewerip into theactualhow-to-do-itpartofforextrading,itisimportanttounderstandhowthemarketworks,howpricesarequotedandordersplaced,andhowtheforeignexchangeplatformprovidersmaketheirmoney.

ForexmarketstructureBeforethedevelopmentoftheinternet,theforexmarketwasthedomainofthelarge commercial banks, large financial institutions, hedge funds and largemultinational corporations. It was essentially a relatively small group of largeplayersinteractingwitheachotherinaclosedshopthatwasbaseduponcreditagreementsamongtheparticipants.Themarketwasnotregulatedandwhiletheseemingly ad-hoc approach of those daysmay seem bizarre to thosewho aremorefamiliarwithtradingonaregulatedexchange,suchastheASX,CMEorNYSE,itactuallyfunctionedveryefficiently.TipBecause the major participants in the forex market compete and cooperate with each other, this self-regulationtendstoensurethatno-oneactstothedisadvantageofanyotherplayer.

The first significant change to this cosy model occurred in 1992 with theintroductionofelectronicdealingplatforms.Theseallowedinter-banktraderstointeractelectronicallyrather thandealingwitheachotherover thephoneorbycable, which increased the speed with which orders could be executed andallowedawideranddeepertradingenvironment.Theabilitytotradeonlinebymeansofatradingplatformalsomeantthatforexcouldnowbemadeavailableto a much wider trading base. Enter some progressive and forward-thinkingmarketmakersanddealers,andtheretailforextradingrevolutionwasborn.

It is best to imagine the spot forexmarket as having a two-tiered structure.Tier one, or the top level, consists of the large banks and other financialinstitutionsthatareconstantlydealingwitheachotheronbehalfofthemselvesortheir clients in the inter-bankmarket.At this level, quantities traded are large,ofteninthemillionsandevenbillionsofdollars,andthepricespreadbetweenthe buy and the sell price is extremely tight. Prices quoted in this inter-bankmarketareknownonlytotheparticipantsandarenotavailableelsewhere.Theinter-bankmarketstillfunctionsasacredit-approvedsysteminwhichthebankstradebasedon thecredit relationships theyhave inplacewitheachother.Thebiggerbankswillhavemoreandlargercreditrelationships,andaccesstobetterpricingandtighterbid/askspreads.Thelargecommercialbanksoperatinginthistieraretheprimarymarketmakersfortheforeignexchangemarket.TipAmarket maker is an organisation that continuously quotes buy and sell prices in the market and isalwayswillingandabletodealatthesequotedprices.

This market-making role ensures there is always a price to trade at, and itprovidescontinuousliquidityforthemarket.Thefactthatanumberofbanksarepreparedtoassumetheroleofmarketmakercreatesanefficientmarket,becauselarge price discrepancies do not occur.Marketmaking also effectively createsthemarket,astheinter-bankdealersbuyandsellamongthemselvesinordertoprofit from these slight variations in price. These variations in price arisebecause each bank will have a different view on the direction they think aforeignexchangeratewillmove.Bankswillalsobeholdingvaryingamounts,orinventorypositions,ofdifferentcurrenciesdependingontheirownneedsandtherequirementsoftheirclients.Thebankdealersmay,forexample,believethattheCanadiandollarisabouttoriseinvalueagainsttheUSdollarbecauseofeventsintheoilandenergymarkets.ThedealersmaybewillingtoofferahigherbidorbuypriceforCanadiandollarstoencouragesomeoneelsetoselltothem,astheybelievethattheycanholdtheseCanadiandollarsforawhileandthensellthemoutagainatahigherprice.Ontheflipside,iftheiranalysissuggeststothemthattheCanadiandollarisabouttofalltheywilllowertheirbidpriceastheydon’treallywanttobuyandhavetoselloutofthepositionlateratalowerprice.Thisability tovarybothbuyandsellprices,and therefore thespread,ordifferencebetween the buy and sell price, is unique to market makers and is possiblebecausetheyarecontinuouslyquotingbothbid(orbuy)andoffer(orsell)prices

inthemarket.

Thesecondtier,orlevel,offorexistheretailforexmarket.Atthislevel,retailtraders gain access to the market through dealer-based electronic tradingplatforms.Retail forex dealers can get access to themarket on behalf of theirclients according to their size and the credit relationships they have with themajorbanksintheinter-bankmarket.Workinginasimilarwaytotheinter-bankmarket, at this level the larger the retail forex dealer is in terms of capitalavailable and creditworthiness, the more favourable the pricing and bid/askspreads itwill receive from the inter-bankmarket.A small retail forex dealerwithfewercreditrelationshipswillberestrictedtodealingwithalimitednumberofthelargerbanksandwillgetlessfavourablepricesandspreadsthanalargeroperator.TipThequotesandspreadsofferedattheretaillevelarenotthesameasthosewithintheinter-bankmarket,butwillverycloselyresemblethem.

Thebanksprovidingquotestotheretailforexdealersmaywidenthespreadsoraddamargintothebuy/sellquotestoassistintheirriskmanagementandalsotomakeaprofit.

RetailforexdealersIfyoualreadytradesharesorfuturesyounodoubthaveabrokerwhoactsasanagentforyouinyourtradingtransactions.Thebrokeracceptsyourorder,eitherbyphoneoroveranelectroniconlineplatform,andthensendstheordertotheexchange,wheretheorder isexecutedaccordingtoyour instructions.Inreturnforthisservice,thebrokerchargesyouacommission.Thebroker’sonlyroleistoacceptyourorder,placeitinthemarket,andchargeyoufordoingso.

The forex market works differently. Unlike the traditional exchange-basedmarkets onwhich shares and futures are traded, the forexmarket, aswe havediscussed,isessentiallyaprincipals-onlymarket.Togainaccesstothemarket,participants must have suitable amounts of capital available and have creditrelationships in place to get access to the inter-bankmarket. Participants thentradeas theprincipal ineachdeal.Forexample, let’sassumethata largebank

client needs to buyUS$20million of euro currency. The bankwould buy theeurosintheinter-bankmarketontheirownaccount,actingasprincipalforthetrade,andthenprovidetheeurocurrencytotheirclient.

Attheretaillevelasimilarprocessoccurs,withthefirmwhereyouraccountis held acting as the principal for your trade within the inter-bank market aseitheramarketmakerordealer.Yourorderisnotsentintotheinter-bankmarketasanordertobuy,say,20000worthofeurocurrencyforMrFredJones; it isseen in themarketas justanotherorder fora firmactingas theprincipal. It isthenallocatedtoyouraccountbythefirmwhereyouraccount isheld.All thistakesplacewithinafewsecondsthroughtheelectronicplatforms,dealingdesksand computer-operatedmatching systems that constitute the foreign exchangemarket.TipThefirmwhereyourretail forexaccountisheldwilloperateinthemarketaseitheramarketmakerordealer.Itisimportanttounderstandthedifferencesbetweeneachandhowthedifferentoperationsaffectyourtradingandyourbottomline.

MarketmakersordealingdesksRetailforexmarketmakershaveaslightlydifferentrolethanthatplayedbythebanksasmarketmakersintheinter-bankmarket,wheremarketmakersfunctiontoprovidecontinuingbuyandsellprices,andprovideliquidityfor themarket.Retailforexmarket-makerfirmswillmaintainbid/askpricesandwillbewillingandabletodealwithclientsatthesepubliclyquotedprices.Thesepricesarenotthepricesoperatingintheinter-bankmarketandmaynotmatchthematall,asthey are derived from the underlying instrument. Themarketmakermay addseveral pricepoints to thebuyand sell prices, andmayalsowiden the spreadbetweenthetwoprices,sometimessignificantly,andthatishowtheymaketheirmoney.

Whenanorderisreceivedfromaclientthemarketmakermay,however,takeanumberofdifferentactions:

⇒Taketheothersideoftheorder.Whenanorderisreceivedfromaclient,theclientisactuallybuyingfromorsellingtothemarketmaker.Iftheclientbuys,themarketmakersellsfromtheirinventory;iftheclientsells,themarketmakerbuysbyeffectivelylendingtheclientinventoryuntilthe

positionisclosed.Whentheclientlosesonatrade,themarketmakerprofits,andviceversa.Themarketmakermayormaynotlay-offtherisk,byplacingthetradeintheactualmarket,dependingontheirviewofmarketdirectionandtheirknowledgeoftheclient’stradinghistory.Ifitisaclientwithahistoryoflosingtrades,themarketmakerwillmoreoftenthannotbetagainsttheclientandnothedgetheposition.Ifitisalarger,moresuccessfulclient,theymaywellhedgethepositioninthemarketandtaketheriskoutofthetrade.

⇒Delaymatchingorders.Oncetheclientorderisplacedandfilled,themarketmakermaywaitanywherefromafewsecondstominutesbeforetheythentradeatabetterprice.Whentheclientclosestheorder,themarketmakermayagainwaitandclosetheorderoutatabetterprice.Thisstrategyworksforthemarketmakermostofthetimebecauseofthehighlosingtraderateamongretailforextradersandthehighpercentageofretailtradesandorderflowsthatareplacedinacounter-trendfashion.

⇒Consolidatesmallerorders.Themarketmakermaywaituntilanumberofsmallerclientordersareplacedbeforelaying-offthepositioninthemarket.Thesmalllotsizeswillbetradedonthemarketmaker’splatformprices,whichmaybedifferentfromthosetradingontheactualmarket,allowingthemarketmakertoprofitfromthepricedifference.

⇒Matchbuyersandsellersinternally.Themarketmakermaysimplymatchabuyorderforacurrencyfromoneclientwithasellorderforthesamecurrencyfromanotherclient.Thiscanhappenonacontinuingbasisthroughoutthedayasbuyandsellordersarereceivedasclientstradeinandoutofpositions.Themarketmakermaybeleftwithsomesmallpositionsattheendofeachday,whichtheythenoffsetinthemarketbybuyingorsellingcurrencytoensuretheyhavenoopenpositionstonullifyanyexposureorrisk.

TipTypically,marketmakersdonotchargecommissionsoraddanadvertisedmark-uptothepricesquotedon their platforms because they are profiting from their client’s activities in other ways, as discussedabove.

Whilecommission-freetradingmayseemappealingitmustberememberedthatthereisnosuchthingasafreelunchinthisworld—particularlyintrading.You

willpayafeetotrade,buthowyoupayitwillvary.Themarketmakerwideningthespreadbetweenthebidandaskpricesisonewaytheycanmakeaprofit,andyour profitability can be reduced. If the market maker widens a spread fromthreepoints tosayfive, thecost toyouhas increasedby twopoints,or66percent.Bywayofexample,let’sassumeyouaretradingat$5perpip.(Thewayforextradingworksisexplainedindetailinchapter5,providingyouwithafullunderstandingofpips, spreads and all theother informationyouneed to tradeforex.Thisexample is includedhere tohighlight the fact that trading is rarely‘free’ and that the trader will incur costs somehow.)With the increase in thespread, itwill now effectively cost you $25 to enter a trade (5 pips at $5 perpip=$25), and itwill also cost you$25 to exit the trade (if the5pip spreadremainsthesame)becauseyouhavetocrossthespreadinorderforyourtradetobeexecuted.Atotalcostof$50—that’shardlyafreetrade.Spreadsforcrossratesandexoticcurrencypaircombinationsmaybemuchhigher.

Marketmakerswillgenerallymanagetheriskofapoolofmanytradersratherthantheprofitandlossofeveryindividualaccountbymanagingthenetpositionofalllong(buy)positionsandallshort(sell)positionsineachcurrencypair.Ateamofinternaltradersanddealerswillmanagethenetpositionasifitwereonelargetradingaccount.Marketmakersmaystill,however,offsetindividualtradesintheinter-bankmarket,dependingontheprofitabilityoftheindividualtrader.Consistently profitable traders can be placed on a separate trade server thatprovides automatic execution and allows their trades to be offset in the inter-bankmarket, thus de-risking each trade for themarketmaker,while they stillmakemoneyonthespread.

A pool of consistently unprofitable traders who are losing money can bemanagedinternallybythemarketmaker’sdealersandtraderswithoutoffsettingeachtradeintheinter-bankmarket.Asthemarketmakeristhecounterpartytotheclient’strades,alossforthetraderrepresentsprofitforthemarketmaker.Ifaclient opens a $10 000 trading account and loses the lot through poor riskmanagement, thenthemarketmakerhasmade$10000profit. If thisoccurs to50tradersina12-monthperiod,thenthemarketmakerhasthepotentialtoearn$500000,justbytakingtheothersideofthepositionsoftheselosingtraders.TipWhilemarketmakersdon’twanttoseetheirclientslosemoney,it’sobviousthatlosingtradersenhancethe market maker’s bottom line. It is this conflict of interest that contributes to some bad press and

negativesentimentforthemarket-makermodel.

Retailforexdealersornon-dealingdesksRetailforexdealersoperateinasimilarwaytobrokersinothermarkets,exceptthat they aredealing as theprincipal.Their role is to serve as an agentof theclientinthebroaderforexmarketbyseekingthebestpriceinthemarketfortheclient’s order and then dealing on behalf of the client.Unlikemarketmakers,retail dealers charge a commission ormark-up on themarket price. They areknownasnon-dealingdesk(NDD)firmsordirectmarketaccess(DMA)firms.These firms access the forex market through an electronic communicationnetwork (ECN) thatmatchesorders fromretail traderswithprices suppliedbythe inter-bank market makers or banks. The infrastructure for these firmsconsists of a computer-based trading screen, or front end, and an applicationprogramminginterface(API)thatdistributesthepricesandavailablequantitiesfromcontributingbanks.TipAnAPIisasoftwareprograminterfacethatallowsinteractionbetweendifferentsoftwareprograms.Itsusemeansthatthesoftwareprogramtheretailforexfirmprovidesandtheclientusersontheirlaptoporhome computer can interact with the various software programs the inter-bank market makers use toprovidepricestotheretailforexfirm.

Theretailforexfirmreceivespricequotesandquantitiesthatthequoteisgood,oravailable,fromthebankmarketmakersintheforexmarket.Thesepricesalsohaveaduration,orlengthoftimeforwhichtheyaregood,oravailable.Asortengine then sorts out the best bids and offers, and quotes these on the retailclient’s softwareprogram.Thisprocess ishappeningcontinuallywhenever theforexmarketisopen.

It ishere that the sizeandcreditworthinessof the retail forex firmbecomesimportantforitsclients.Thelargerthecapitalisationofthefirmandthebetteritscredit rating, the more banks it will have access to. This means it will haveaccess to awider range of prices and price spreads in themarket andwill bebetterabletoservetheneedsofitsclients.Asthebanksarecompetingforyourbusiness, the greater the number of banks, the greater the competition amongthemtoofferbetterpricesandtighterbid/askspreads.Italsomeanstradescanbeexecutedmorequickly, as therearemorepricequotesbeingofferedby thedifferentbanksfromwhichtochoosethebestbidorofferatanyonetime.The

retail firm FXCM, for example, has access to prices provided by 11 top tierbanks.

Oncetheretailforexfirmreceivesthepricequotes,andwhiletheyarebeingsortedaccordingtothebestavailableprice,amark-up,ormargin,isaddedtothepricebythedealerbeforethepriceisquotedtotheretailclientontheirtradingplatform.Whenwe,asretailclients,seeapriceonourtradingplatforms,weseethepricefromthebankthatcurrentlyhasthebestbidoroffer,plusthemark-upchargedbythedealer.TipThemark-upisthecommissionchargedbythenon-dealingdesk(NDD)ordirectmarketaccess(DMA)firm,andit’showtheymaketheirmoney.

OtherfeaturesoftradingwithaDMAorNDDretailforexfirminclude:

⇒anonymity.BecausetheDMAorNDDfirmisactingasprincipalforalltheretailtradersthatareitsclients,ordersappearinthebankmarketascomingfromtheretailforexfirm,andnotfromindividualclients’accounts.Clientorderstobuyorsellremainontheretailforexfirm’sserverandaresentintothemarketelectronicallyasmarketordersoncethepricehasbeenreached.Thebankscan’tseewheretheordersaresitting.Thedownsideisthatinafast-movingmarkettheretailclientwillexperienceslippage(seetipoverleaf).

⇒nomaximumtradesize.Whiletheretailforexmarketmakersmayimposetradesizelimitationsbecauseoftherisksforthemintakingtheopposingsideoflargepositions,DMAorNDDforexdealerswill,asageneralrule,acceptlargeordersizes,uptoUS$50millionpertrade,throughtheirelectronictradingplatforms.Thislimitationwillnotadverselyaffectthemajorityofonlineretailforextraders.Multipleparcelsofordersofthissize,orlargesingleorders,canbeplacedbytelephoningtheseordersthroughtothedealingdesk.

⇒variablepricespreads.Astheyareprovidingpricequotesdirectfromanumberofprovidersthatareconstantlyebbingandflowingandbeing‘sorted’forthebestavailabledeal,itisnaturalthatthepricespreadswillvaryinlinewithsupplyanddemandandothereconomicandnewseventsthatcontinuallycausechangesinprice.

⇒nopricerequotes.Apricerequoteissaidtooccurwhenanorderisnotfilledattherequestedpriceandthetraderisofferedanother,differentprice.Arequotemaybetheresultofaslowtransferofdataandpriceinformation,oraliquidity-relatedissuewheretheamountrequestedisunavailableattherequestedprice,ortheresultoftradinginafast-movingmarketwherethedealingfirmmaybeexposedtoalargerriskthannormalbytheirholdingapricefortoolong.DMAorNDDdealerswillfillordersatthenextavailableprice,ratherthanofferrequotes.

TipSlippageoccurswhenarestingstoporlimitorderisfilledseveralpipsaboveorbelowtherequiredprice.Onceastoporlimitorderpriceistriggered,itthenbecomesanatmarketoratbestorder,anditwillbefilled at the next available price. In a fast-moving, volatile market, or in cases where liquidity istemporarilyreduced, thismayresult in thepositionbeingfilledatasignificantlydifferentrate thantheonerequested.Slippagecanoccurinallmarkets,notjusttheforexmarket.

ChoosingaretailforexdealerthatsuitsyouWhenassessingtheforexdealeryouwilltradewith,itisimportanttochooseareputabledealingfirmthat iswellcapitalised,hasstrongrelationshipswiththebanksandcandelivertheliquidityyouneedtotradeeffectively.Youalsoneedto know and understand the impact on your trading of all fees, charges,commissionsandcosts.TipInchoosingyourdealeryoualsoneedtoconsidertheramificationsofbothtypesofserviceprovider—market maker or non-dealing desk — as discussed above. When dealing with a market maker, nocommissionispayable,butyoumaynotbegettingthebestpriceavailable,andtheserviceprovider,bytaking theopposite sideofyour trade,hasaconflictof interest inyour successasa trader.Thedirectmarketaccess(DMA)dealerchargescommissionormark-uponeachtrade,sothemoreyoutradeandthemoreprofitableyoubecome,themorecommissiontheycanearn.

Havingidentifiedandchosenthetypeofserviceprovideryouwanttotradewith—marketmaker orDMA, and the cost structure, fees and commissions theycharge—followingaresiximportantpointstoconsiderwhenselectingtheretailforexfirmwithwhichyouchosetotrade.

Aretheyregulated?Ifso,inwhichcountry?Whilethespotforexoperatesasanover-the-countermarketthatismostlyself-regulatedandsubjecttolittlegovernmentorexchangeregulation,itisimportantfor a retail trader to choose a foreign exchange dealer firm that is based in acountrywhere theiroverallactivitiesand licensingarrangementsaresubject toregulationsandmonitoredbyaregulatoryagency.TipAdealerlocatedinacountrywithoutstrictregulatoryguidelineswillnotbesubjecttothesametradeandcreditcontrolrulesasonethatis.

Themajor forex trading countries that have regulatory bodies, and the bodiesthatregulatethem,include:

⇒Australia—AustralianSecurities&InvestmentsCommission(ASIC)

⇒UnitedStates—CommoditiesandFuturesTradingCommission(CFTC);SecuritiesandExchangesCommission(SEC);NationalFuturesAssociation(NFA)

⇒UnitedKingdom—FinancialServicesAuthority

⇒Eurozone—MarketsinFinancialInstrumentsDirective(MiFID)

⇒Canada—InvestmentIndustryRegulatoryOrganizationofCanada(IIROC)

⇒Japan—FinancialServicesAgency(FSA);FinancialFuturesAssociationofJapan(FFAJ);JapanSecurityDealersAssociation(JSDA)

⇒Switzerland—SwissFinancialMarketSupervisoryAuthority(FINMA).

Regulatoryauthoritiesare located inmanyothercountries,and tradersneed tobeawareoftheirdealer’sregulatorystatus.

Whatistheircapitalisation?Thebettercapitalisedretailforexdealerfirmsare(inotherwordsthemoretheyareworth and themoremoney theyhave asworking capital), themore creditrelationships they are able to establish with the banks and other liquidityproviders,andthemorecompetitivepricingandspreadstheyareabletoachieve

fortheirclients.Thisalsomeansthat,undervolatilemarketconditions,theywillbeabletooffercontinuouspricingwithouttheneedtorequote.

TheOTC nature of the spot forexmarket requires the retail forex firms todepositanamountofmoney(referredtoasmargin)withthebanksthatprovidepricesandspreads to them.Obviously, themorecapital theretail firmhas, themorebanks theycandepositmarginwith inorder to securecredit and tradingrelationships.TipAretailforexfirmthatisnotwellcapitalisedwouldfinditdifficulttoremaincompetitiveinthemarket.

In theUS,dealersare required tobemembersof regulatoryassociations.Asamemberofaregulatorybody,adealermustcomplywithminimumcapitalisationlevels.AsatJune2010,thisfigurewassetatUS$20million.Ifadealerdoesnotmakeinformationabouttheregulatoryrequirementofcapitalisationavailabletoclientsanddoesn’tmeettherequirements,thatmayindicatealackofsolvency.

Howuser-friendlyandreliableistheirtradingplatform?The online trading platform supplied by your chosen broker is your interfacewiththeforexmarket,soitneedstobebothsimpleandeasytouse,yetstillofferallthenecessaryfeaturesandtoolsyouneed,andbeeasytonavigatearoundtoaccess these features. Features may include the provision of news and otherinformation,real-timeorlivepricechartsandchartingtools,economicdataandaccesstopricesonimportantcommodities,suchasgoldandoil.TipTheabilitytoopenandclosetradesquicklyisamajorconsiderationinchoosingyourbroker.Thestepsneededtoplacebuyandsellorders,aswellasanystopandlimitentryandexitorders,shouldalsobeasimpleprocess.Inafast-moving,volatilemarketyouneedtobeabletoplaceorderswithasfewmouseclicksaspossible.Slowtradeentryandorderexecutionmayresultinlostopportunities.

Theplatform also needs to be very stable, and not crash or freeze up.This isparticularly important during times of increased activity around major newsevents and announcements, when trading activity may spike suddenly. Thereliabilityoftheplatformtoholdupunderpressureandnotlockupisperhapsevenmoreimportantthanthelookandfeeloftheplatform.

Whilethesefeaturesare important toall traders, theyareessentialforshort-termoraggressivetraderswhomakefrequenttradesandneedtoenterandexittradesquicklyandefficiently.Secondslostnavigatingaroundaclunkyplatformcanprovecostly, and socanplatformcrashesor freezes.These issuesare lessimportant,thoughstillrelevant,toamoreconservative,medium-termtraderwhomaybuyandsellonstopandlimitorders,ratherthanmarketorders.Thevariousordertypesusedarediscussedinchapter6.

Wewill also take amoredetailed look at tradingplatforms andhow tousetheminchapter5.

Whatcustomersupportdotheyprovide?The 24-hour nature of the forexmarket and the fact that nomatterwhat yourtimezoneyoucanchoosetotradewheneveritsuitsyou,shouldalsomeanthatyourproviderhasa24-hoursupportdesk.JustbecauseitisthemiddleofthedayinSydneyandnight-time in thenorthernhemispheredoesn’tmeanyoushouldnot have access to customer support for your technical and account-relatedquestions. You need prompt answers to any issues that arise. You should nothavetowaithoursuntilthesupportdeskontheothersideoftheworldopensat9.00amNewYorktime,ortheaccountsdepartmentintheSingaporeofficeturnup forwork.Nor shouldyouhaveaccess to customer supportonlyduring thedaylighthoursof thecityof thecompany’sheadoffice.Theforexmarketruns24hoursaday,socustomersupportneedstobethesame.Theretailforexdealerfirms that are serious about their client relationships make 24-hour supportavailable.

Youalsoneedtoknowhowyoucancontactthesupportdeskandwhatmeansofcommunicationareavailable.Thisshouldincludeemailandlivechat,aswellas being able to speak on the telephone. Support must be available in yourlanguagesothatproblemsandissuesareclearlyunderstoodandthenrectified.

Whattypesofaccountsdotheyoffer?As well as standard accounts, many retail forex firms also offer small miniaccountsandsmallermicroaccounts.Astandardaccounttradesstandardlotsof$100000face-valuepositions,andmultiplesof$100000;aminiaccounttrades

minilotsof$10000face-valuepositionsandmultiplesof$10000;andamicroaccounttradesmicrolotsof$1000face-valueandmultiplesof$1000.Miniandmicroaccountsallowtraderswithsmallamountsofcapitaltoparticipateintheforexmarketbyreducingtheirriskandexposurethroughsmallerpositionsizesand trade values.Youwill need to check that your chosen provider offers thetypeofaccountthatisthebestfitfortheamountofcapitalyouhaveavailable.

Whatleverageisofferedandwhatistheirmargincallpolicy?Adetaileddiscussionofleverageandmarginfollowsinchapter5.Theimportantthingstoconsiderwhenselectingyourforexdealeraretheleveragelevelstheyofferandwhethertheselevelsarefixedorvariable,dependingonthecurrencybeingtraded.Sometradersmaychoosetheirdealerbasedonthehighleveragelevels offered without understanding the implications of incorrectly usingleverage.Whilehighleveragecanleadtohigherprofitsandgreaterpercentagereturnsonavailablecapital,italsoincreasesthelevelofrisk.Themisuseofhighlevelsofleverageisoneofthemainreasonsnewtradersfailintheirattemptstotradeforex.

It is also important tounderstand themargincallpolicyofyour retail forexfirm. If you do get a margin call through over-exposure and poor moneymanagement,youneedtoknowhowthedealerwillhandleyouraccount.Somefirms use the first-in-first-out (FIFO) method to close trades when marginrequirementsfallshortofcurrentavailableequity—thatmeanstheywillcloseout older positions first in order to reinstatemargin requirement levels.Otherfirmsusethelast-in-first-out(LIFO)method,meaningtheywillclosethemostrecenttradesfirst.Otherfirmswillsimplycloseall trades.Thisisanotherareathatyouneedtoidentifyandclarifybeforeyoustarttrading.

The structure of the spot forex market, and the main differences betweendealers and how theymake theirmoney, have now been outlined. In the nextchapterwewillexamineall theother informationyouneed toknowabout thespotforexmarket.

Chaptersummary

⇒Beforethedevelopmentoftheinternet,theforexmarketwasthedomainofthelargecommercialbanks,largefinancialinstitutions,hedgefundsandlargemultinationalcorporations.

⇒Itisbesttothinkofthespotforexmarketashavingatwo-tierstructure.Tierone,orthetoplevel,ismadeupofthelargebanksandotherfinancialinstitutionsconstantlydealingbetweeneachother,ontheirownbehalforonbehalfoftheirclientsintheinter-bankmarket.Thesecondtier,orlowerlevel,istheretailforexmarket.Atthislevel,retailtradersgainaccesstotheforexmarketthroughdealer-basedelectronictradingplatforms.

⇒Unlikethetraditionalexchange-basedmarketsonwhichsharesandfuturesaretraded,theforexmarketisessentiallyaprincipalsonlymarket.Togainaccesstothemarket,participantsmusthavesuitableamountsofcapitalavailableandhavecreditrelationshipsinplaceinordertobeabletogainaccesstotheinter-bankmarket.

⇒Retailforexbrokersareeithermarketmakersornon-dealingdeskfirms.

⇒Marketmakersgenerallyactasthecounterpartytotheirclients’tradesbytakingtheoppositesideofthetrade.

⇒Non-dealingdeskfirmsactasanagentfortheclient,transactingintheinter-bankmarketonbehalfoftheclient.

⇒Retailtradersneedtocarefullychooseareputabledealingfirmthatiswellcapitalised,hasstrongrelationshipswiththebanks,andcandelivertheliquiditytheyneedtotradeeffectively.Retailtradersalsoneedtoknowandunderstandtheimpactofallfees,charges,commissionsandcostsontheirtrading.

⇒Itisimportantforretailtraderstospendtimeresearchingthedifferentretailforexdealersandseekingouttheinformationtheyneedtomakeaninformeddecisiononwhichfirmtheywillchoosetotradewith.

Chapter5:Themechanicsoftradingforex

Let’snowtakeadetailedlookat thespecific informationyouneedtoknowtotradethespotforexmarketwithconfidence,tofullyunderstandwhatthemarketis,howtotrade,andtheuniqueaspectsoftheforexmarket.

TradingforexistradingmoneyForex trading is the simultaneous buying of one currency and the selling ofanother. Currencies are traded through a retail forex dealer, and are traded inpairs: forexample, theAustraliandollarand theUSdollar (AUD/USD)or theeuroandtheJapaneseyen(EUR/JPY).Buyingacurrencyislikebuyingashareinaparticularcountry.WhenyoubuyAustraliandollars,forexample,youareineffectbuyingashareintheAustralianeconomy.

Theforexspotmarketdoesnothaveaphysical locationorcentralexchangewherebuyingandsellingtakesplace,orthroughwhichalltradesareexecuted.Itis an off-exchange or over-the-counter (OTC)market placewhere buyers andsellers interact with each other electronically through a network of banks,financialinstitutions,dealersandothermarketparticipants.

Untilthelate1990s,onlythebigguyscouldparticipateinforextrading.Theinitial requirement for trading in forex was a trading account of more thanUS$10 million. That meant the forex market was used only by banks,governments and other large financial institutions, and not by smaller retailtraders and speculators. The development of the internet, the free floating ofcurrenciesanddevelopmentsintechnologyhaveallowedforextradingfirmsandbrokerstooffertradingaccountstoretailtraderslikeyouandme.TipAll the major currencies are assigned a three-letter abbreviation expressed using InternationalOrganizationforStandardization(ISO)codesforeachcurrency.

TheISOcodesformanyofthemajorworldcurrenciesarelistedintable5.1.

Table5.1:ISOcurrencycodesformajortradingcurrencies

ThemechanicsofforextradingAnexchangerateissimplytheratioofonecurrencyagainstthevalueofanother.The NZD/USD exchange rate, for example, indicates what the New ZealanddollarisworthwhencomparedtotheUSdollar.Currenciesarealwaysquotedinpairs because in every foreign exchange transaction you are simultaneouslybuying one currency and selling another, or exchanging the value of onecurrency for that of another. This exchange of values is unique to the forexmarketandcanbealittledauntingtogetyourheadaroundinitially.

Inthesharemarketorfuturesmarketwhenyoubuyashareoracommodity,yourexpectationisforthevaluetoincrease,allowingyoutosellforaprofit.Ifyoubuy1000sharesinacompanyat$5.00pershareandthepriceincreasesto$5.50pershareyouhavemadeaprofitof50centspershare,or$500.00(1000shares×50 cents per share).Tobank theprofit, you simply sell the shares to

whoeveriswillingtopay$5.50pershare.

In the forexmarket if you anticipate the value of theAustralian dollarwillrise,what is itgoingtorise invalueagainst?Asitcannotsimplyrise invalueagainstitself;ithastoincreaseinvaluerelativetothevalueofanothercurrency,suchastheUSdollar.IfthevalueoftheAustraliandollarhasrisenagainsttheUSdollar,thenitfollowsthatthevalueoftheUSdollarhasdeclinedrelativetotheAustraliandollar.Ifwethinkofitintermsofthesharemarket,whenwebuyshareswearesellingourcash,andwhenwesellshareswearebuyingcash.

Baseandquote(orcounter)currenciesCurrenciesarealwaysquotedinpairs.Thefirstcurrencyinthepairisknownasthebasecurrency.Itisthecurrencyyouarebuyingorsellingandisthebasisforthe transaction. It also represents the face value, or notional, amount of thetransaction. Ifyoubuy100000NZD/USD,forexample,youhave justbought100000NewZealanddollarsandsoldtheequivalentamountofUSdollars.

Thesecondcurrencyinthepairiscalledthequotecurrencyorsometimesthecounter currency.Thequote currency represents thedenominationof thepricefluctuationsandyourprofitandlossesonthetrade.So,aswithourNewZealanddollarexampleabove,youwouldactuallybebuyingNZD100000worthofNewZealanddollarsandsellingtheequivalentamountofUSdollars,andyourprofitorlossonthetradewouldberecordedinUSdollars.TipCurrenciesarealwaystradedinpairs.

Asanexample,iftheNZD/USDexchangerateis0.7500,youwouldbebuyingNZD100000worthofNewZealanddollarsatarateof0.7500,andatthesametimesellingUSD133333(NZD100000dividedby0.7500).Inotherwords,wehavetopay0.7500USdollars tobuy1NewZealanddollar.Inorderforus tomakeaprofit,thevalueoftheNewZealanddollarmustriseinvaluerelativetotheUSdollar.Tip

Thecurrency listedonthe leftof theslash(/) is thebasecurrency,andthecurrencyontheright is thequotecurrency.

CurrencypairsThe most actively traded currency pairs are referred to as the majors andgenerally involve theUS dollar on one side of the deal. ThemajorUS dollarcurrencypairsare listed in table5.2.Theseare the sevenmostactively tradedcurrencypairs.

Table5.2:majorUSdollarcurrencypairs

TipAnycurrencypairthatdoesnotinvolvetheUSdollarisreferredtoasacrosscurrencypair,crossrateorcross.

Cross rates are derived from the respective US dollar–related pairs but arequotedindependently.TheEUR/JPYcrossrate,forexample,isderivedfromtheEUR/USD exchange rate and theUSD/JPY exchange rate. Cross rates enabletradingofcurrencypairsthatmayhaveauniquerelationshipbetweencountries,such as the AUD/JPY where imports and exports between the two countriesdon’tneed to include theUSdollar.Cross ratesalsoallowus to target tradingopportunitiesthatmayexistinspecificcurrencypairsandtotakeadvantageofprice patterns, economic data or news events that impact specifically on thesecross currency pairs. Some of the most actively traded currency crosses are

shownintable5.3(overleaf).

Thesevenmajorcurrencypairslistedintable5.2andtheninecrosscurrencypairslistedintable5.3accountformorethan90percentofallcurrencytradingactivityacrossallcurrencytradingmarketsandinstruments.

Table5.3:activelytradedcurrencycrosses

Longorshort?Asinanytrading,whenyouarebuyingtoopenatradeyouaregoinglongandwhenyouaresellingtoopenatradeyouaregoingshort.

If you buy the currency pair— that is, buy the base currency and sell thequotecurrency—youwant thebasecurrencytorise invaluesoyoucanthensellitatahigherpriceandmakeaprofit.

Ifyoushortsellthecurrencypair—thatis,sellthebasecurrencyandbuythequotecurrency—youwant thebasecurrency to fall invaluesoyoucan thenbuyitbackatalowerpriceandmakeaprofit.TipBuying to open is called going long or taking a long position. Selling to open is called going short,shortingortakingashortposition.

UnderstandingpipsApip is thesmallest incrementalpricemoveofacurrencypair.PIPstandsforpercentage in point or price interest point. In forex, prices are quoted to fourdecimal points so the change in the fourth decimal point is equal to one-thousandthoftherateor0.0001or0.01percent,hencethetermpercentageinpoint.If,forexample,theGBP/USDisquotedat1.5715,thenthesmallestmoveitcanmaketotheupsideis1.5716(1.5715+0.0001)andthesmallestmoveitcanmaketothedownsideis1.5714(1.5717–0.0001)—thatis,a1pipmoveineitherdirection.

The exception to this rule is any currency pair involving the Japanese yenwherethepricequotesaretakentoonlytwodecimalplaces,orone-hundredthoftherate,astheyenhasalowerunitvaluethantheothermajorcurrencies.If,forexample,theUSD/JPYisquotedat83.45,thenthesmallestmoveitcanmaketothe upside is 83.46 (83.34 + 0.01) and the smallest move it canmake to thedownsideis83.44(83.45–0.01)—thatis,a1pipmoveineitherdirection.

Herearelistedsomecurrencypairvalueswiththepipshowinbold:

AUD/USD:0.9818

EUR/USD:1.3304

USD/JPY:83.37

USD/CAD:1.0286TipThepipisthelastwholenumberinthequotedprice.

In forex, trading profits and losses aremeasured in pips, so it is important tounderstandwhatapipis.

Pips are used in forex trading because there is no one currency in whichvaluescanbeindicatedandbecausewearemeasuringthevalueofonecurrencyrelativetothevalueofanother.AlthoughtheUSdollaristhemostwidelytradedcurrency and is traded against most other currencies, it is not involved in alltrades. Pip values can be calculated for any currency pair in values that arerelevanttoeachparticularpairandarecalculatedinunitsofthequotecurrency,

ratherthaninUSdollars.Someexamplesincludeeuro/Japaneseyen(EUR/JPY)—pipvalues calculated inyen; euro/Britishpound (EUR/GBP)—pipvaluescalculated in British pounds; and Australian dollar/New Zealand dollar(AUD/NZD)—pipvaluescalculatedinNZdollars.TipThemonetaryvalueofapipchangesaccordingtothecurrenciesinvolvedinatrade.

LotsizesSpot forex is traded in lots. In order to profit from the tiny pip incrementsdescribedabove,youneedtobeabletotradelargeamountsofacurrencypairinordertoseeanysubstantialprofitorloss.Ifyoujustwentlong1Aussiedollar(buyingAUD/USD)at0.9885,forexample,andthepricewentupto0.9890,anincreaseof5pips, youhavemade0.0005centson the trade—notworth theeffort.Butbecausetheforexmarkettradesinlots,youareabletosignificantlymagnifythisresult.Let’stakealookatwhathappenswhenyoubuyorselllotsofvaryingsizes.

The lot sizeyouare able to tradewill dependon theamountof capitalyouhave available in your trading account, your risk profile, and the amount ofleverageyou are able to apply to your account.Leveragewill be discussed inmoredetaillaterinthischapter.TipAstandardlotis100000unitsofthebasecurrency.Aminilotis10000unitsofthebasecurrency.Amicrolotis1000unitsofthebasecurrency.

Wenowneedtocombineourknowledgeofpipsandpipvalueswiththelotsizewe are trading to determine the dollar value of each pip and to allow us tocalculateprofitandloss.

Example1Let’s continue with the Aussie dollar example, going long at 0.9885 inanticipationofariseinthevalueoftheAussiedollarrelativetotheUSdollar.

Using a standard lot: you buy 100 000Aussie dollars and sell 101 163USdollars.

Usingaminilot:youbuy10000Aussiedollarsandsell10116USdollars.

Usingamicrolot:youbuy1000Aussiedollarsandsell1012USdollars.

Solution

Todeterminethedollarvalueofeachpip,dividetheminimumpipmovebytheexchangerate.

YouhaveboughtAUD/USDat0.9885.

0.0001/0.9885=AUD0.000101.

Nowmultiplythisresultbythelotsizetodeterminethedollarvalueofeachpip.

Forastandardlot,AUD0.000101×100000=AUD10.10.

As theAussiedollar is thebasecurrency,wecanconvert thepipvalue intoUSdollarsbymultiplyingtheAussiedollarpipvaluebytheexchangerate.

AUD10.10×0.9885=USD9.98,roundedup=USD10.00perpip.

Thesameprocesscanbe followed todetermine thepipvalues forminiandmicrolots,arrivingatUSD1.00forminilotsof10000andUSD0.099(10cents)formicrolots.

An increase in thepriceof theAUD/USDpair from0.9885 to0.9890,or5pips,wouldincreaseourreturnfromameasly0.0005centsto:

USD50.00forastandardlot(5pips×USD10.00perpip)

USD5.00foraminilot(5pips×USD1.00perpip)

USD0.50foramicrolot(5pips×USD0.10perpip)

Theactionsinvolvedinthistradeareshownintable5.4.

Table5.4:profitcalculationusingastandardlot

Example2Anycurrencypair thathastheUSdollaras thebasecurrencydoesnotrequirethe step to convert back toUS dollars because the initial calculation is inUSdollars.Let’swork throughanexampleofbuyingUSD/CADat1.0285,wheretheUSdollaristhebasecurrency.

Solution

0.0001/1.0285=0.0000972.

Multiplybythelotsizetodeterminepipvalueindollars.

ForastandardlotUS$0.0000972×100000=US$9.72.

ForaminilotUS$0.0000972×10000=US$0.972.

ForamicrolotUS$0.0000972×1000=US$0.097(9.7cents).

Example3We can also calculate pip values for the yen, but need to remember that anycurrencypairthatinvolvestheJapaneseyenonlyinvolvestwodecimalplaces.

Solution

BuyUSD/JPYatanexchangerateof84.10.

0.01/84.10=0.0001189.

Multiplybythelotsizetodeterminepipvalueindollars.

ForastandardlotUS$0.0001189×100000=US$11.89.

ForaminilotUS$0.0001189×10000=$1.19.

ForamicrolotUS$0.0001189×1000=US$0.12(12cents).TipYouronline tradingplatformwillcalculatepipvalues foryoubut it is important toknowhow theyarecalculatedandwhypipvaluesvaryforeachcurrencypair.

Thebid/offerspreadAllforexquotesincludeatwo-wayprice—thebidandtheask.Thebidorbuypriceisalwaysshownontheleft-handside,andtheaskorsellpriceisalwaysdisplayedontheright-handside.Theaskpriceisalsocalledtheofferprice.

The bid price is the price that the buyer is willing to pay to buy the basecurrency,andrepresentsthepriceatwhichyoucansell.

The ask or offer price is the price that the seller iswilling to sell the basecurrency,andrepresentsthepriceatwhichyoucanbuy.

Thepricequotesof thebidand theofferwillhave twocomponents: thebigfigureandthedealingprice.Thebigfigurereferstothewholedollarpriceofthequote, and the dealing price refers to the last two digits. The big figure isgenerally shown in smaller type, while the dealing price is shown in largerand/ormorebrightlydisplayedtype.Anexampleisshowninfigure5.1.

Figure5.1:thebigfigureanddealingprice

Source:FXCMTradingStation,<www.fxcm.com>.

In this exampleof theUSD/CADcurrencypair thebig figure is1.01, and thedealingpriceis0.0008bid/0.0011offered.Youcanalsoseethatthebidpriceorthepriceatwhichyoucansellis1.0108,andtheaskorofferpriceatwhichyoucanbuyis1.0111.

Thedifferencebetweenthebidandtheaskpricesisreferredtoasthespread.Thespreadbetweenthebidandtheaskpriceinthisexampleis3pips(1.0111–1.0108)andrepresentsthecostofestablishing,oropening,aposition.Fromtheoutsetofatrade,thetradermustrecoverthecostofthespreadbeforetheymakeany profit. The spread also represents the minimum move required by thecurrencypairbeforethepositionisatbreakevenforthetrader.LookingatourexampleoftheUSD/CAD,ifyoudecidetobuy,youwillpay1.0111andthepaircurrentlyhasa3pipspread.Inorderforustobreakeven,ormakenoloss,onthis trade, theoffer pricewouldhave tomoveup to1.0114, and thebidpricewould thenmove to 1.0111, assuming the spread remained at 3 pips. This isreferred toascrossing thespread,and it isanunavoidable factof life forspotforextraders.

Widerspreadsresultinhigheraskandlowerbidprices.Thewiderthespread,themorethepricehastomoveinthetrader’sfavourbeforetheyareinprofitonatrade.Marketmakersmakemostoftheirprofitthroughthepricespread—youcan now understand how. In a fast-moving or volatilemarket they canwidenspreads,makingitharderforthepriceofacurrencypairtomoveintoprofit,or

increasinglossesbypushingpricesartificiallyhigheror lowerthroughawiderspread,orboth.TipTighter spreadsmeanmoreprofits for tradersandare the reasons it iswise to stick to themore liquidcurrencypairs,wherethebidandofferpricesareclosertogether,andtradewithretail forexfirmsthatmaintaintightpricespreads.

HowthetraderandthedealercanbothmakeaprofitSincetheobjectoftradingistomakeaprofitandthedealingfirmsarealsoinbusiness togenerateaprofit,weneed to lookathowboth tradersanddealingfirms can make profits on the same transaction. A trader decides to buy onestandardlot(100000)ofAUD/USD.TheDMAorNDDfirmplatformshowsa3pipspreadofsay0.9657/0.9660,allowingtheclient toplaceanordertobuy(golong)AUD/USDat0.9659throughtheonlinetradingplatform.Thedealerrelays the order through its back-endbridgeorAPI to the banks and liquidityproviders that it has credit relationships with, and it receives the followingtradeablebid/offerprices:

BankA:AUD/USD0.9657/0.9658

BankB:AUD/USD0.9656/0.9657

BankC:AUD/USD0.9658/0.9659

The dealer confirms the trade to the client at the quoted price of 0.9660,representing 0.9659 (the price from Bank C) plus a 1 pip mark-up, orcommission.ThedealingfirmthenoffsetsthetradebybuyingfromBankBat0.9657(thelowestaskprice,fromBankB).Byoffsettingthetradeintheinter-bankmarketthefirmisabletoremainneutralastowhethertheclientmakesorlosesmoneyonthetrade.

Themarketmoves in the trader’s favour,and thedealingfirmplatformnowshowsAUD/USDat0.9757/0.9760(thebestbid/askpriceplusa1pipmark-up),andsotheclientclosesthetradebysellingat0.9757(thebidprice).Atthesame

time, the dealer sees the following tradeable bid/offer prices from its bankmarketmakers:

BankA:AUD/USD0.9757/0.9758

BankB:AUD/USD0.9756/0.9757

BankC:AUD/USD0.9758/0.9759

Thedealing firmcloses its longpositionbyselling in the inter-bankmarketat0.9758(thehighestbidpricefromBankC).

Let’scheckouttheresultsforboththetraderandtheDMAorNDDfirm.

Theclientopensthetradeat0.9660andclosesitoutat0.9757,foragainof97pips.Ononestandard lotwithapipvalueofUS$10perpip, theclienthasmade$970profit(97pips×$10perpip).

Thedealingfirmopens the tradeat0.9657andcloses itoutat0.9758, foragainof101pips,or$1010,plusa1pipmark-uponeitherside,or$20,makingagain of $1030. From this they have to pay the client the $970 profit, leaving$60.00, and fees to theirprimebrokerandotherparties,whichmay total$20,leavinganetprofitof$40.Nowmultiplythisbythethousandsoftradesbeingtransacted every day! Bear in mind, however, that the dealing firm has otherhidden costs, such as the provision of trading platforms, price streaming, andmaintainingsupportdesks,servicessuppliedfreeofchargetotheclient.

FractionalpipsA recent development by some retail forex dealing firms has been theintroductionoffractionalpips,byaddinganotherdigitontothecurrencypairs—either a fifth digit for most currencies or a third digit for pairs involving theJapaneseyen.This isnotawholepip,butone that isone-tenth thevalueofawholepip.Fractionalpipshavelongbeenavailableintheinter-bankmarket.TipTheavailabilityoffractionalpipsservestonarrowthespreadbetweenthebidandtheask.

Figure5.2showsaquoteofEUR/USDwithfractionalpips.

Figure5.2:EUR/USDwithfractionalpipsquoted

Source:FXCMTradingStation,<www.fxcm.com>.

Asyou can see, the full pip bid is 1.3221, and the offer is 1.3224, or a 3 pipspread.

However,thisplatformalsoshowsfractionalpipsthatareone-tenthofafullpip.Thesearethe‘6’onthebidsideandthe‘2’ontheaskside.Oncethesearetaken into consideration, the spread between the bid and ask is now 2.6 pips(1.3224 2/10 − 1.3221 6/10). The availability of fractional pips narrowed thespreadby0.4ofafullpip.Ononestandardlotof100000thisrepresentsaroundUS$4.TipRemembernottocountthefifthdigitasawholepip.

Whilefractionalpipsservetonarrowthebid/askspread,remembernottocountthemaswholepipswhencalculatingentryprices,stoplossesandprofittargets.Ifyouforgetandusethemaswholepipsyoucanbetriggeredinoroutofatradebymistake.Forexample,sayyousetastoploss50pipsunderyourlongentryprice.Ifyoucountthefifthdigit(orthirddigitinapairinvolvingtheyen)thenyouwill have set your stop only 5 pips away from your entry point and youcouldgetstoppedoutwithinafewseconds.

The sameapplieswhen setting aprofit target.Youmay set a target 80pipsawayfromyourentryprice,butifyoumistakenlycalculatethepriceusingthefractionalpips,youwillsetthetargetonly8pipsaway.TipDon’tusefractionalpipswhencalculatingstopsorprofittargets.Beawarethatyourplatformusesthemandthattheybenefitthespread,butfocusonlyonthewholepipsforyourcalculations.

MarginandleverageWhen trading forex,we are trading using leverage.As the instruments have aminimum trade size in units of the base currency (1 standard lot = 100 000units),theuseofmarginisnecessary.TipTheconceptsofleverageandmarginworkhandinhand,butbothtermshaveverydistinctmeaningsanditisimportanttounderstandboth.

Leverage is the use of financial instruments or borrowed capital (such as amargin tradingaccount) to increase thepotential returnof any investment.Putanotherway,leverageistheabilitytocontrolalargeamountofmoneybyusingsome of your own cash and borrowing the rest. Any financial product orinstrumentthatallowsyoutocontrolalargerpositionthanwouldbepossibleifyouweretradingtheunderlyinginstrumentusingyourownmoneyinvolvestheuseofleverage,andiscalledaderivative.Inthisway,allderivatives,includingspot forex, are leveraged as they allow the use of relatively small amounts ofcapital to control much larger face-value positions. As a result, a smallmovement in the price of the underlying instrument results in a much largerchangeinthevalueofthederivative.

Leveragecanbethoughtofasaloanthatisprovidedbythedealerorbrokerwithwhomyourtradingaccountisheld.Themoneydepositedintoyourtradingaccountisusedasasecuritydepositagainstthefundsthatyouborrowtocontrolmuchlargerpositions—inotherwords,wehavebeenable to leverageupthecashintheaccount.Let’slookathowleveragecanworktoincreasebothprofitsandlossesinatradingsituation.

Youenteratradebuyingonestandard($100000)lot,anditincreasesinvalue

to$102000,givingyouaprofitof$2000.Ifyoucouldonlyuseleverageof1:1youwouldneed to stumpup the full$100000amount,andyouwouldearnareturnof2percentonthetrade.If,however,youwereusingleverageof100:1(effectively borrowing $100 000), for example, you would only need tocontribute$1000ofyourowncashtocontrolthesame$100000position.Thereturnonyourcapitalwouldnowbe200percent($2000profit/$1000ofyourcapitalused).

If,ontheotherhand,thepositionfellto$98000,youhavenowlost$2000.Ifyouhadstumpedupthefull$100000(leverageof1:1)youhavea–2percentreturn, or 2 per cent loss.However, if youwere trading on leverage of 100:1using $1000 of your ownmoney, your returnwould be –200 per cent ($2000loss/$1000capital).TipYoucannowseewhyleverageisreferredtoasadouble-edgedsword.

Leveragecanbedefinedasgainingassistanceoradvantagethroughtheuseofatoolorlever.Thetoolorleverintradingtermsistheuseofmargin.Tradingonmarginmeansthatyouareabletoenterintopositionsthataremuchlargerthanthe balance of cash in your trading account. The cash held in your tradingaccount serves as a safetydeposit, or collateral, for thebrokeror dealer, fromwhom you then borrow the balance.Margin serves as collateral to cover anylosses that may occur. Since nothing is actually being purchased or sold fordelivery, only the promise to exchange the difference in cash between twoprices, the only real purpose for having funds in an account with a dealer orproviderisforsufficientmargintobeavailablewithwhichtotrade,andtocoveramountslostinlosingtrades.

Leverage is often used to describe trading onmargin, and is descriptive ofmargin trading requirements, as the two termsgohand inhand.A leverageof100:1,forexample,impliesamarginrequirementof1percent.Inotherwords,ifyouwishtoopenapositionusingaleverageof100:1youarerequiredtohave1 per cent of the size of the position available as cash in yourmargin tradingaccount.Asanexample,toopenapositionwithafacevalueof$100000(onestandard lot), using leverage of 100:1 would require a 1 per cent margin, or$1000.To open a positionwith a face value of $10 000 (onemini lot), usingleverageof100:1wouldrequirea1percentmarginor$100.Aleverageof50:1

implies amargin requirement of 2 per cent. To open one standard lot using aleverageof50:1wouldrequireamarginof$2000.Aleverageof200:1impliesamarginrequirementof0.5percent,meaningastandardlotcouldbeopenedwithamarginof$500.TipMarginrequirementsandtheleverageavailablewillvaryfrombrokertobroker.

Basedonthemarginrequiredyoucancalculatethemaximumleverageavailabletoyouasshownintable5.5.

Table5.5:marginandmaximumleveragelevels

Oneoftheattractionsofthespotforexmarkettomanytradersistheavailabilityofhighleveragelevelsandtheuseofmargin.Withoutthese,tradingforexwouldbebeyondthereachofthevastmajorityofretailtraders,whowouldbeunableto place trades in lots of $100 000 with a 1:1 leverage. The availability ofleverageandtheuseofmarginallowsmalltradersaccesstothemarket.TipWithout the use of leverage and margin, retail forex trading would not be financially viable becausemassivemovesincurrencypriceswouldbeneededinordertogenerateprofits.

Theuseofamargintradingaccountmeans,forexample,thatwecantechnicallycontrol $100 000 worth of a currency pair, using a leverage of 100:1 and amargin requirement of 1 per cent,with $1000 of our own cash.Aswe knowfrom the earlier examples, the value of 1 pip on one standard $100000 lot isworth around$10. If the value of the currencypair rises by50pips,wehavenowmade$500.Without theuseofmargin, ifwe couldonlypurchase$1000worthof thecurrencypair, thesame50pipmovewouldreturna$5profit.To

makethesame$500profitwithouttheuseofleverageandmarginwouldrequirea5000pipmove.

Misunderstandingandmisusingleverageandmarginis thekeyreasonmanyretailforextraderslosemoneyandblowuptheirtradingaccountswhentradingforex.Wewilltakeadetailedlookintowaystoappropriatelymanagetherisksinvolvedinforextradingusingleverageandmargininchapter9.TipJustbecausethebrokerofferstheabilitytotradewith200:1leveragedoesn’tmeanyouhavetodoit.Theamountofleverageyouusewilldependonyourbrokerandwhatyoufeelcomfortablewith.

WhentotradeforexWhile the forexmarket is open 24 hours per day for five and a half days perweek,fromitsopenearlyMondaymorninginNewZealandtothecloseoftheNew York session in the early hours of Saturday morning Sydney time, themarketisnotalwaysactiveandsometimesarebetterthanotherstotrade,whenactivity, and so intra-day liquidity, is higher. This is particularly relevant forshort-term intra-day traders who need high levels of market activity andvolatility togenerate thepricefluctuations theyneedwhenattempting tomakelotsoftradesforsmallprofits.Itislessimportantformoremedium-termtraders,whoarekeyingtheirdecisionstobuyandselloffend-of-dayprices.TipAlthoughthespotforexmarketisreferredtoasoperating24hoursaday,thereisactuallyabriefperiodbetween the close of theNewYork session and the beginning of theNewZealand session. End-of-daytradersandtradingsystemsusethesetimesastheopenandcloseforeachday’stradingsession.

ThelargestamountoftradingvolumeinforexoccursduringtheLondonsession,followedbytheNewYorksessionandthentheTokyosession.Duringthetimeswhenthesecentresaretrading,activityisatitshighest.Thesearetheimportanttimes for short-term traders,andunfortunately for thoseofus inAustraliaandNewZealandthereallyactivetradingduringtheLondonandNewYorksessionsoccurs during our night-time. Table 5.6 shows the approximate opening andclosingtimesforeachofthemajorsessionsastheforexmarketfollowsthesunaroundtheglobe.

Table5.6:forexsessiontradingtimesforSydney,Tokyo,LondonandNewYork

Thesetimesmaybeapproximateduetotheeffectsofdaylightsavingatdifferenttimesoftheyearindifferenttimezones.ThemarketdoesopeninNewZealandafewhoursbeforetheSydneyopen,butactivitytendstobelightuntilSydneygetsstarted.TipThereallyhigh levelsofactivityandvolatility tend tooccurwhen twotradingsessionsareopenat thesametime,particularlywhenLondonandNewYorkareopentogether.

Thecross-overtimes,whenforexmarketsareopentogether,areshownintable5.7.

Table5.7:overlappingtradingsessionsfortheforexmarket

TipThetimeswhenbothNewYorkandLondonareopentogetherisreferredtoastheNYLON.

Though trading activity is at its highest during the London and New Yorksessions,activitydoesbuildupthroughtheSydneysession,andwhenTokyoandSydney areopen simultaneously.This is particularly so in the local currenciesforthesetwotradingsessions—Aussiedollarcrossesandyencrosses.

Chaptersummary

⇒Buyingacurrencyislikebuyingashareinaparticularcountry.

⇒Untilthelate1990s,onlythebigguyscouldparticipateinforextrading.Theinitialrequirementwasatradingaccountinexcessof$US10million.

⇒Theexchangerateofacurrencyisitsrelativevaluecomparedwiththepriceofanothercurrency.

⇒Currenciesarealwaysquotedinpairs.Thefirstcurrencyinthepairisknownasthebasecurrency.Thesecondcurrencyinthepairiscalledthequotecurrencyorsometimesthecountercurrency.

⇒ThemostactivelytradedcurrencypairsarereferredtoasthemajorsandgenerallyinvolvetheUSdollarononesideofthedeal.AnycurrencypairthatdoesnotinvolvetheUSdollarisreferredtoasacrosscurrencypair,crossrateorcross.

⇒CrossratesarederivedfromtherespectiveUSdollar–relatedpairsbutarequotedindependently.

⇒Apipisthesmallestincrementalpricemoveofacurrencypair.Pipstandsforpercentageinpointorpriceinterestpoint.

⇒Currenciesaretradedinlots—standardlotsof100000,minilotsof10000,andmicrolotsof1000.

⇒Allforexquotesincludeatwo-wayprice—thebidandtheask.Thebidorbuypriceisalwaysdisplayedontheleft-handside,andtheaskorsellpriceisalwaysdisplayedontheright-handside.Theaskpriceisalsocalledtheofferprice.

⇒Widerspreadsresultinhigheraskandlowerbidprices.Thewiderthespread,themorethepricehastomoveinthetrader’sfavourbeforetheyareinprofitonatrade.

⇒Arecentdevelopmentbysomeretailforexdealingfirmshasbeentheintroductionoffractionalpips.

⇒Leverageistheuseoffinancialinstrumentsorborrowedcapital(suchasamargintradingaccount)toincreasethepotentialreturnofanyinvestment.

⇒Tradingonmarginmeansthatyouareabletoenterintopositionsthataremuchlargerthanthebalanceofcashinyourtradingaccount.

⇒Theforexmarketisopen24hoursadayforfiveandahalfdaysperweek,fromitsopenearlyMondaymorning,Sydneytime,inNewZealandtothecloseoftheNewYorksessionintheearlyhoursofSaturdaymorningSydneytime.

Chapter6:HowtoplaceaforextradeNowthatwehavediscussedindetailtheworkingsofthespotforexmarketandtheimportantconceptsofcurrencypairs,pips,lotsizes,bid/askspreads,thebesttimestotradeforexandtheuseofleverageandmargin,itisnowtimetolookattheprocessofactuallyplacingtradesonaforextradingplatform.Inthischapterwewillworkthroughtheprocessofplacingatradeatmarket,aswellastheuseofstopandlimitorders.Wewillalsotakealookattheprocessofrolloverandtheuseofcarrytradestoprofitfrominterestratedifferencesbetweencurrencypairs.

PlacingatradeHaving chosen your preferred retail forex dealer and opened and funded yourmargintradingaccount,nowcomestimetoplacetrades.Yourtradingdecisionsto buy and sellwill be based on fundamental or technical analysis techniquesthat are beyond the scope of this book. Your position sizing and moneymanagement ruleswill bedictatedbyyour account size, appetite for risk, andriskmanagement,which arediscussed in chapter9.For the sakeof simplicityandeaseofoperation, let’s assume thatyouhaveopenedanaccountwith$15000andyouareabletotrademinilots(10000)onthisaccount.

OpeningatradeatmarketOpeningatradeatmarket,oratbest,meansyouarewillingtodealimmediatelyat the prevailing bid or offer. If you want to buy at market, you take theprevailingaskorofferprice(thepricethesellerisofferingandthusthepriceatwhichwemustbuy).Thisisreferredtoashittingtheoffer.Ifyouwanttosellatmarket,youtaketheprevailingbidorbuyprice(thepricethebuyeriswillingtopayandthusthepriceatwhichwemustsell).Thisisreferredtoashittingthebid.

Intheexampleshowninfigure6.1oftheAUD/USDcurrencypair,youcan

seethatthebid(thepriceatwhichwecansellatmarket)is0.98512⁄10andtheask(thepriceatwhichwecanbuyatmarket)is0.98540⁄10.

Figure6.1:AUD/USDbid/ask

Source:FXCMTradingStation,<www.fxcm.com>.

Inordertobuyatmarket,orhittheoffer,simplyclickonthebuysideandthewindowshowninfigure6.2appears.

Figure6.2:buyingatbest,oratmarket

Source:FXCMTradingStation,<www.fxcm.com>.

You can clearly see that we have selected to buy one mini lot ($10 000) ofAUD/USD.ToexecutetheordersimplyclickontheOKbuttonandtheorderissenttomarket,andtheorderwillbefilledattheofferprice.

Ifweweresellingtoopenashortpositionatbest,wewouldfollowthesameprocess,butclickingonsellratherthanbuy.

UsingstopandlimitorderstoenteratradeAtbestordersareusedtoenteratradeimmediately,butstopandlimitorderscanbe used to enter trades above or below the prevailingmarket price. Stop andlimit entry orderswill be usedmore by end-of-day andmedium-term traders,who are waiting for some price-or momentum-based confirmation beforeenteringatrade.

Onthebuyside,stoporderscanbeusedtoenteratradeabovetheprevailingprice,andlimitorderswillbeusedtoenteratradebelowtheprevailingmarketprice.

On theshortorsellside,stoporderswillbeused toentera tradebelowtheprevailingmarketprice,andlimitorderswillbeusedtoenteratradeabovethe

prevailingmarketprice.

Thewaytoenteranorderonstoporlimitwillvaryfromplatformtoplatform,sothefollowingprocessmaydifferdependingontheplatformbeingused.Someplatformswill require thatyouenter theorderasastopora limitbyselectingone of these options from a drop-down menu; others will recogniseautomaticallythattheorderiseitherastoporlimitorderdependingonthepricethe trader sets in their order to open the trade compared with the prevailingmarketprice.Theexampleshowninfigure6.3isfromsuchaplatform.

Let’sworkthroughanexampleofbuyinglongonastop(abovetheprevailingmarketprice)using theEUR/USDcurrencypair.Figure6.3showsthebidandofferpricesbeingdisplayedontheplatformfortheEUR/USDcurrencypair.

Figure6.3:bid/askspreadforEUR/USD

Source:FXCMTradingStation,<www.fxcm.com>.

Let’s assume youwant to buyEUR/USD at 1.3195 (ignoring fractional pips),whichisabovethepresentofferpriceof1.3189(ignoringfractionalpips).Youarebuyingonstopasyourbuypriceisabovethecurrentmarketprice,andyoudon’t want to enter this trade until you have confirmation that the price ismovinghigher.

Thenextstep is to right-clickon thebid/askwindow; thewindowshowninfigure6.4willappear.

Figure6.4:buyingEUR/USDonstop

Source:FXCMTradingStation,<www.fxcm.com>.

In this window, select the rate at which you want your entry order to beexecuted; in thisexampleofEUR/USD,it is1.3195.WethenclickontheOKbutton,andtheorderissenttothedealertoawaitexecutionwhenorifthepricereachesourpredeterminedentryprice.

Theorderwillappearinouraccountasapendingorwaitingorder,asshowninfigure6.5.

Figure6.5:EUR/USDpendingorder

Source:FXCMTradingStation,<www.fxcm.com>.

Thesameprocessisfollowedtoenterabuylimitentryorder,andstopandlimit

short-sellentryorders.

You can also enter any predetermined stop loss and profit target prices youhaveforatrade.TipAstoplossdeterminesthepriceatwhichyouwillexitatradethathasmovedagainstyoutoapricelevelthat correspondswith themaximum amount of capital you are prepared to lose on any one trade. Alltradesmustbeenteredwithapredeterminedstop-losslevelset.

TipAprofittargetisapredeterminedpriceatwhichwewillexitaprofitabletrade.

UsingtheEUR/USDexample,youhavenowsetthepriceatwhichyouwanttoenterthetrade.Atthesametimeyoucanenterthestoplossandtheprofittargetsforthistrade.Forthisexample,let’sassumeyouwanttosetastoploss50pipsbelowtheentrypriceandaprofittarget100pipsabovetheentryprice.

Youronstopentrypriceissetat1.3195.Thestoplossis1.3195−50pips=1.3145.Theprofittargetis1.3195+100pips=1.3295.Wenowentertheseasshowninfigure6.6.

WhenyouclickontheOKbutton,thewholeorderissenttothedealer.Theonstopentryordernowhasbothastoplossandaprofittargetorderattachedtoitasshowninfigure6.7.Neitherofthesewillbeactivateduntiltheoriginalbuystoporderisfilled.Alllegsorsidesoftheordercanbecancelledorchangedatanytime.

Figure6.6:stoplossandprofittargetforEUR/USD

Source:FXCMTradingStation,<www.fxcm.com>.

Figure6.7:EUR/USDwithallthreelegs

Source:FXCMTradingStation,<www.fxcm.com>.

Thesameprocessisfollowedtosetupshortsellentryorderswithstoplossessetabove the entry price and profit targets set below the entry price. The above

examples show the platform functionality of the Trading Station platform offorextradingfirmFXCM.TipTradingplatformswillvaryinhowyouenterandsetorders.It isveryimportanttofamiliariseyourselfwiththeoperationoftheplatformyouareusingandhowtoenterthevariousordertypes.

RolloverRollover is a way of extending the settlement date of an open spot forexposition.Usually in spot forex currency trades, youmust take delivery of thecurrencyanddeliverthecurrencyyouhaveborrowedorsoldtwodaysafterthetransaction date. By simultaneously closing out of the existing position (bysellingthebought,orlong,sideofthetradeandbuyingbackthesold,orshort,sideofthetrade)atthatday’sclosingpriceandre-enteringattheopeningpricethefollowingday,youhaverolledthepositionover to thenextdayandaddedanotherdaytothesettlementdate.Thisrolloverprocesscanbecontinuedforanindefiniteperioduntilyoudecidetocloseorexittheopenpositionwhenaprofitprice is reached or you close the position at a loss. Your forex dealing firm,acting on your behalf, automatically executes the rollover process in youraccount.TipIfyouholdaspotforexpositionovernight—thatis,thepositionisrolledover—thenyoumaypayorreceivewhatiscalledtherolloverfee.

Formostforextraders,whoaimtomakeaprofitfromthechangesinexchangeratesratherthanactuallytakingdeliveryofthecurrency,rollover(whichisoftenreferredtoastomorrownext)isusefulbecauseitallowstradestobeheldopenindefinitely,astheopenpositioncanbecontinuallyrolledoveruntilsuchtimeasthetradeisfinallyclosed.Everycurrencytradeinvolvesborrowingonecurrencytobuyanother,sowhenyourolloveranopenposition, rolloverchargescomeintoplay.Youmayhave topay interest on the currency that is borrowed, andmayreceivetheinterestearnedontheonethatisbought.Ifyoubuyacurrencypairwherethebasecurrencyhasahigherinter-bankinterestratethanthequotecurrency,thenyouwillreceiveinterest,orarolloverfee;ifthebasecurrencyhasalowerinterestratethanthequotecurrency,youwillhavetopayinterest,ora

rolloverfee.Forexample,ifyoubuytheAUD/USD,andtheinter-bankinterestratesarehigherinAustraliathanintheUS,thenyoumayreceivearolloverfee(interestmaybecreditedtoyouraccount).Ontheotherhand,iftheinterestratesarehigherintheUS,thenyoumayhavetopayarolloverfee(interestchargeswillbedebitedfromyouraccount).

Rolloverfeesdonotaffectdaytraderswhoclosetheirpositionsattheendofeach trading day.Rollovers only apply to any overnight open position carriedovertothenextday.Rolloversfeesareappliedtoopenpositionsafter5pmESTintheUS,afterthecloseoftheNewYorktradingsession.

ThecarrytradeTheavailabilityof therollover functiongives rise to themostpopular trade intheforexmarket—thecarrytrade.Itisatradingstrategyemployedbythelargehedge funds and fund managers, but smaller traders can use it just as easily,albeitonasmallerscale.

Thecarrytraderevolvesaroundthefactthateverycurrency’svaluerelativetoanother’siscloselyrelatedtotheinterestratesinthetwocountriesinvolved.Theideabehindthecarrytradeistomakeuseofthesedifferencesininterestratestoearn a profit by buying (going long) a currencywith a high interest rate andselling(goingshort)acurrencywithalowinterestrate.TipThecarrytradeusesthefactthatwhenwearetradingforexweareactuallyborrowingthecurrencywearesellingtofinancethepurchaseofthecurrencywearebuying.

Thebasisofthecarrytradeistogolongacurrencypairwherethereisalargedifferenceininterestrates,sothattheinterestearnedonthelongcurrencymorethancoverstheinterestyouhavetopayontheshort,orborrowedcurrency.Evenwithoutanybeneficialmovementinthepriceofthepair,theinterestearnedcanbequitesubstantialbecauseoftheuseofleverage.Ifweuseonestandardlotof$100000asanexample,andtheNZD/JPYcurrencypairwheretheinterestratedifferential has been as high as 7.25 per cent,we can do somemaths to helpunderstandtheworkingsofthecarrytradeandthebenefitsoftheuseofleverageinusingthisstrategy.

Withouttheuseofleverage,a$100000positionata1:1leveragewouldhaveearneda7.25percentreturnoraround$7250.Ifweassumethatthistradecouldhave been entered with the use of 100:1 leverage, or a 1 per cent marginrequirement,thenthesame$100000positiononlyrequirestheuseof$1000ofavailabletradingcapital.Sincethecarryappliestothefacevalueoftheposition,wehavestillearned$7250,buthaveonlyused$1000ofourcapitalasmarginfor the trade—a725percentannual return!Youcannowseewhy thecarrytrade isapopular trade. Ifyouadd thefact that thevalueof thepairmayalsoincreaseinvalue,thenthereturnscanbebetterstill.Figure6.8showstheriseinvalue of the NZD/JPY pair between 2002 and 2007, as the interest ratedifferential increasedfromjustunder5percent tomorethan7percentas theReserveBankofNewZealandraisedrates,andinterestratesinJapanremainedat0.0percent.

Figure6.8:NZD/JPYcarrytradeexample,2002to2007

Source:TradeNavigator©GenesisFinancialTechnologies,Inc.

Whatisalsoevidentfromthischartisthat,likealltrades,youstillneedapointatwhichyouwillexitthetradewhenitstartstomoveagainstyou.Despitethedifference in interest ratesand the returns thatcouldbeearned from thiscarrytrade, when everything turned sour during the global financial crisis in 2008,eventhehigh-yieldingcarrytradeswereunwoundastradersandinvestorsbailed

outofhigh-yieldingandperceivedhigh-riskcurrenciessuchastheNewZealanddollar, and sought solace in cash or safe-haven currencies like the US dollar,JapaneseyenandSwissfranc.Whencarrytradesareunwound,thedeclinescanbeswiftandsevere,asinthepreviousexample,aseveryonerunsfortheexitatthe same time. The profits from the carry are not enough to offset the capitallosses,sothecarrytradesareliquidated.TipCarrytradescanbeagreatwaytoprofitfrominterestratedifferentials,butyoumuststillknowwhentoexitthetrade.

Chaptersummary

⇒Openingatradeatmarket,oratbest,meansyouarewillingtodealimmediatelyattheprevailingbidoroffer.

⇒Onthebuyside,stoporderscanbeusedtoenteratradeabovetheprevailingprice,andlimitorderswillbeusedtoenteratradebelowtheprevailingmarketprice.

⇒Ontheshort,orsell,side,stoporderswillbeusedtoenteratradebelowtheprevailingmarketprice,andlimitorderswillbeusedtoenteratradeabovetheprevailingmarketprice.

⇒Variouscombinationsofstopandlimitorderscanbeusedtoenterandexittradesdependingonyourtradingstyleorthetradingsystemorstrategybeingused.

⇒Rolloverinforextradingisawayofextendingthesettlementdateofanopenposition.

⇒Theavailabilityofrollovergivesrisetothemostpopulartradeintheforexmarket—thecarrytrade.Itisatradingstrategyemployedbythelargehedgefundsandfundmanagers,butsmallertraderscanalsouseit,albeitonasmallerscale,tobenefitfromdifferencesbetweentheinterestratesinthecountrieswhosecurrenciestheyaretrading.

Chapter7:Currencyfutures

The primary reason for the existence of the foreign exchange market is tofacilitate theexchangeofonecurrencyforanother toassist international trade.Overtimetheforexmarkethasdevelopedasanefficientmeansforbuyersandsellers who hold different currencies, and who have different views on therelativevaluesofcurrencies,tofindeachotherandconducttrades.Thishasseena massive increase in speculative trades in order to generate profits from themovementsincurrencyexchangerates.Anumberofinstrumentsareavailabletomarket participants, whether hedgers or speculators, whowant to trade forex.The two main instruments available to retail forex traders are the spot forexmarket,asdiscussedindetailinchapter5,andcurrencyfutures.

CurrencyfutureshavebeenavailablesincetheirintroductionbytheChicagoMercantileExchange(CME)in1972,andtheirusebytradershasbeensteadilyincreasing over the years. While much of the discussion, marketing andpromotionalactivitiessurroundingthetradingofforexhavetodealwiththespotforexmarket, trading currency futures is also a greatway toparticipate in theforexmarket.Forexistingfuturestraders,currencyfuturesareanothercontracttheycansuccessfullytrade.TipFor new and potential traders getting started in the forex market, currency futures need to be fullyconsideredandunderstoodasaviablealternativetotradingspotforex.

Currencyfutures,andhowtheycomparewithspotforex,arethesubjectsofthischapter.WewillalsobelookingattradingcurrencyfuturesontheCME,astheCMEisthelargestregulatedmarketfortradingcurrencyfutures:ithadadailyturnoverin2009ofmorethanUS$100billion.

ThemechanicsoftradingcurrencyfuturesLike spot forex, currency futures express thevalueofonecurrency relative to

the value of another or the value of the exchange rate between the twocurrencies. As with the spot forex market, currency futures are also alwaysquotedinpairs,andthesameterminologyapplies.Thefirstcurrencyinthepairisknownasthebasecurrency.Itisthecurrencyyouarebuyingorsellingandisthebasisforthetransaction.Thesecondcurrencyinthepairiscalledthequotecurrencyorsometimesthecountercurrency.

PricequotesareoftenreferredtoasbeingeitherEuropean-orAmerican-stylequotes and are based on historical trading conventions that have becomeinternationally accepted standards. These terms reflect the position of the USdollar in the currency pair. European-style quotes express the amount ofcurrency thatcanbeexchangedforUS$1.TheUSdollar isquotedfirstand isthe base currency.European-style quotes for forex pairs are only used in spotforex.American-stylequotesexpress theamountofUSdollarsneededforoneunitoftheforeigncurrency.TheUSdollarisquotedsecondandisthequoteorcounter currency. American-style quotes are always quoted in US dollars andcents.TipJustaswithspotforex,theexchangerateincurrencyfuturesisthepriceofthebasecurrencyintermsof,orrelativeto,thequotecurrency.If,forexample,theEUR/USDpairisquotedat1.3695,thismeansthat1eurocanbuy1.3695USdollars,orthatittakes1.3695USdollarstobuy1euro.

MajorfuturescontractstradedontheCMEarequotedinAmericanstyle.Table7.1(overleaf)liststhemajorcurrencypairsavailableasfuturescontractsontheCME;theseareoftenreferredtoastheG10currencypairsbecausetheycontainthecurrenciesoftheG10countries.TheymaybestandardpairsthatcontaintheUSdollar,orcurrencycrosses,orcrossratesthatdonotcontaintheUSdollar.Cross rates do not contain the US dollar, and express the value of the basecurrencyintermsofthequotecurrency.TheEUR/GBPcrossrate,forexample,reflectshowmanyBritishpoundsyoucanbuyfor1euro.

Asidefromtheirusebytradersandspeculators,crossratesareimportantforcompanies and other entities trading in global markets, but who don’t needexchangeratesinvolvingtheUSdollar.AmanufacturerlocatedinJapanthatisexportingtoawholesalerinFranceismoreinterestedintherelativevalueoftheyentotheeuro(EUR/JPYcrossrate)thantheyentotheUSdollar(USD/JPY).

Table7.1:majorcurrencyfuturespairsonCME

Source:CMEGroup.

InadditiontothecurrencyfuturescontractsavailableontheG10currencypairs,futurescontractsarealsoavailableonmanyexoticpairsorcurrencycrossrates.ThesecurrencyfutureshavebeendevelopedbytheCMEtoallowtraderstogainaccesstoexchangeratemarketsthattheyareotherwiseunabletotrade,suchasthe Chinese yuan, Korean won, and many others. Table 7.2 is a list of thecurrencyfuturescontractsavailableonthesecurrencypairs.Theyarereferredtoasemergingmarketcurrencypairs.TipAn economy in the process of industrialisation, and thus having only a short association with globalfinancialmarkets,isreferredtoasanemergingmarket.

Emergingmarketcountriesareoftensubjecttomoregeo-political,economicandsocialriskthanthemoreeconomicallydevelopedcountries.Asaresult,highervolatility and potential risk are often associated with the currencies of theseemergingmarketcountries.

Table7.2:emergingmarketcurrencypairsonCME

Source:CMEGroup.

TipWhen trading the emergingmarkets contracts liquiditywill bemuch less thanwhen trading themajorcurrencyfuturescontracts.Bid/askspreadsmayalsobewider.

The largest of these emergingmarket economies areBrazil,Russia, India andChina.TheyareoftenreferredtoastheBRICeconomiesorBRICcountries—Brazil is the largest of the Latin American economies, Russia is still thedominant economy in eastern Europe, India is the second-largest economy inAsia,withaburgeoningmiddleclass,andChinahasthelargesteconomyinAsiaandisrapidlybecomingaleadingworldeconomy.TheBRICcurrenciesaretheBrazilianreal,Russianrouble(orruble),IndianrupeeandChineseyuan.

Longorshort?Currencyfuturescanbetradedlongorshortwiththesameeaseasinspotforex.Going long (buying) and going short (short selling) are the twomajor futurestrading strategies. Traders and speculators are able to take a long or shortpositiondependingontheirviewofthemarketandtheirexpectationsoffuturepricemoves.

If, for example, you expect the price of the Aussie dollar to increase youwouldbuy,orgolong,anAustraliandollarcurrencyfuturescontractandcloseoutofthepositionforaprofitwhenthepricerises—benefitingfromtherisein

price.If,ontheotherhand,youexpectadeclineinthevalueoftheAussiedollaryoucansell,orgoshort,anAustraliandollarcurrencyfuturescontractandbuyitbackagainforaprofitwhenthepricesfalls—benefitingfromthedeclineintheprice.TipThe forex markets provide ample opportunities for trading both long and short, so it is important tounderstandthetwoconceptsandbeabletotradebothsidesofthemarketorpricetrend.

Becausefuturescontractsareexchangeablebetweenpartiesbeforethesettlementorexpirydate,tradersandspeculatorsareabletobuyandsellcontractstoprofitfromthepricefluctuationsthatareoccurringconstantly.Thisabilitytoeliminatean open position by buying or selling the opposite position is known asoffsetting.IfyouareshortaCanadiandollarcontract,forexample,yousimplybuybackaCanadiandollarcontractandyourtradingaccountiseithercreditedifyouhavemadeaprofit,ordebited ifyouhaveincurreda loss. Ifyouare longandwishtocloseoutthetrade,yousimplysell.

NovationInordertohandletheconstanttransferoffuturescontractsbetweenbuyersandsellers, futures exchanges have developed clearing operations that record alltransactionsanddocumentthetransferofcontractsbetweenthepartiesinvolved.Thisclearingoperationassumestheroleofathirdpartytoeverytransactioninamatchingprocesscallednovation.Inthisprocesstheclearinghouseassumestheroleofbuyeragainst theoriginalbuyerandselleragainst theoriginal seller. Itoperates as though the seller has sold to the clearing house and the buyer hasboughtfromtheclearinghousetoensuretheintegrityofeverytrade.

Byplacing itselfbetween the twocounterparties toevery trade, theclearinghouseguarantees thateach tradewillbehonouredandsettledas setout in thefuturescontract,andsobuyersandsellersdonotdealdirectlywitheachother,avoidingexposuretocreditandcounterpartydefaultrisk.Thisnovationprocesscanbeusedbecausethenumberoflongcontractsisalwaysequaltothenumberof short contracts, and the clearing house is continuallymatching buyerswithsellersthroughtheregulatedexchangeprocess.Itensuresadefault-freetrading

environmentforalltraders.TipTheresultoftheactionsoftheclearinghouseisthatfuturescontractsneverexistdirectlybetweenabuyerandaseller—eachclienthasacontractwith theclearinghouse,greatlyreducing therisksof tradersdealingdirectlywithunknownparties.

StandardisedcontractsandspecificationsUnlikethedecentralisedOTCspotforexmarket,currencyfuturesaretradedonaregulated exchange, such as the CME and others that provide rules andregulationsfortradinginthesefinancialproducts.Asaresult,currencyfuturescontracts,likeallfuturescontracts,havestandardspecifications—contractsize,expiryordeliverydate,andminimumpriceincrementandcorrespondingvalue.Thismeansthatall thefeaturesof thecontractare thesametoeachbuyerandseller;theonlyvariableisprice,andpricerisesandfallsinlinewithsupplyanddemand.

Figure7.1 shows the features of a standardisedAUD/USDcurrency futurescontract,whichwewilldiscussindetail.

Figure7.1:Aussiedollarfuturescontractspecifications

Source:CMEGroup.

Delivery(ormaturity)dateAll futures contracts have a defined expiry date, when they must be eitherdeliveredorsettledincashdependingonthetermsofthecontract.Thedeliverydates for currency futures are typically the thirdWednesday of March, June,

September and December. The last trading day— the last day on which thecontracts can be bought or sold before delivery day— is generally two daysbefore.Mostcurrencyfuturescontractsareclosedoutbeforethelasttradingdaywithtraderstakingprofitsorcuttingtheir losses,avoidingtheneedforcashordeliverysettlement.

SettlementCurrencyfuturescontractscanbesettledinoneoftwoways.Mostareoffsetbybothbuyersandsellerstakinganoppositepositiontotheircurrentopenpositionbeforethelasttradingday:atraderwithanopenlongpositionwillsellanequalnumber of contracts to close their open position; a trader with an open shortpositionwillbuybackanequalnumberofcontractstoclosetheiropenposition.A profit is then credited to the trader’s account, or a loss is debited from thetrader’saccount.

Far less frequently,contractsarehelduntil thematuritydate.Contractshelduntilexpirymustbeeithercashsettledorphysicallydelivereddependingonthetermsofthecontract.Standardcurrencyfuturesaresubjecttophysicaldelivery,whichmeansthattheholderofalongpositionatthematuritydatewillreceivethespecifiedamountofthecurrency,whiletheholderofanopenshortpositionatthematuritydatemustdeliverthespecifiedamountofcurrency.Thisprocessis facilitated through the relevant futures exchange clearing house and thenovationprocess,andpaymentsarenotmadedirectlybetweenthebuyerandtheseller.Theclearinghousecollectsthecurrencythatmustbedeliveredfromtheseller (the traderwith theopen shortposition), andwilldeliver it to thebuyer(thetraderwiththeopenlongposition).

ContractsizeCurrencyfutureshaveastandardcontractsizeexpressedinthebasecurrency.Asshown in figure 7.1, the Australian dollar futures contract is for 100 000Australiandollars.Thisisoftenreferredtoasthefacevalueofthecontract.Thecontractsizesfortheotherstandardcurrencyfuturescontractsareshownintable7.3.

Table7.3:standardfuturescontractsizesforthesixmajortradingcurrencies

UnderstandingtickvaluesFuturescontractsalsoindicate theminimumpriceincrement,givingrise to thetickvalue,orthesmallestvaluebywhichthevalueofthecontractscanchange.TheAussiedollarcontractaboveshowsaminimumpriceincrementof0.0001,andacorrespondingtickvalueof$10($100000facevalue×0.0001=$10).

As an example, if an Aussie dollar trade is entered long at 0.9867, theminimumnextpriceitcanmoveuptois0.9868(0.9867+0.0001=0.9868)andthe minimum next price it can move down to is 0.9866 (0.9867 – 0.0001 =0.9866).This0.0001pointmoveisworth$10percontract.Ifthepricemovesupfrom 0.9867 to 0.9887, this is a 0.0020 point move, called a 20 point move,representingamoveof$200percontract(20points×$10perpoint=$200).Ifthepricemovesupfrom0.9867to0.9967,thisisa0.0100pointmove,calleda100pointmove,andrepresentsamoveof$1000percontract(100points×$10perpoint=$1000).

Table7.4showsthecontractsize,minimumpriceincrementsandtickvaluesforthemoreactivelytradedandliquidcurrencyfuturescontracts.

Table7.4:currencyfuturesdetails

E-microcurrencyfuturesE-micro forex futures were introduced in March 2009 in recognition thatstandard currency futures contractsmay be too large, in both size andmarginrequirement,forsmallretailtraders,andtocompetewiththeflexibilitysmallertraders have in tradingmini andmicro lots on the spot forexmarket.E-microcontracts are roughly one-tenth the size of the standard currency futurescontracts.Figure7.2showsthee-microcontractfortheAustraliandollar,clearlyshowingtheone-tenthdifferenceinthesizeofthecontract.

Figure7.2:e-microAustraliandollarcontract

Source:CMEGroup.

The e-micro futures contracts available in late 2010 and their tick values areshownintable7.5.

Table7.5:e-microcontractsizes,minimumpriceincrementsandtickvaluesavailableinlate2010

TheAussiedollare-microcontractrepresentedintable7.5hasaminimumpriceincrementof0.0001,andacorrespondingtickvalueof$1($10000facevalue×0.0001=$10).Asanexample,ifanAussiedollartradeisenteredlong(buy)at0.9867,theminimumnextpriceitcanmoveuptois0.9868(0.9867+0.0001=0.9868)and theminimumnextprice itcanmovedown to is0.9866(0.9867–0.0001=0.9866).This0.0001pointmoveisworth$1percontract.Ifthepricemovesupfrom0.9867to0.9887,thisisa0.0020pointmove,calleda20pointmove,andrepresentsamoveof$20percontract (20points×$10perpoint=$20).Ifthepricemovesupfrom0.9867to0.9967,thisisa0.0100pointmove,calleda100pointmove,andrepresentsamoveof$100percontract(100points×$1perpoint=$100).TipE-micro contracts can be used by traders wanting to trade smaller lot sizes on a regulated exchange

ratherthantheunregulatedover-the-counterspotforexmarket.

Bid/askspreadAllforexquotesincludeatwo-wayprice—thebidandtheask.Thebidorbuypriceisalwaysdisplayedontheleft-handside,andtheaskorsellpriceisalwaysdisplayedonthe-righthandside.Theaskpriceisalsocalledtheofferprice.

The bid price is the price that the buyer is willing to pay to buy the basecurrency,andrepresentsthepriceatwhichyoucansell.

The ask or offer price is the price that the seller iswilling to sell the basecurrency,andrepresentsthepriceatwhichyoucanbuy.

Thedifferencebetweenthebidandtheaskpricesisreferredtoasthespread.

Figure7.3showsthebidandofferpricesfortheMarch2011Australiandollarfuturescontracts.Thebidpriceisclearly0.9737andtheaskpriceis0.9739,aspreadof2ticks.

Figure7.3:AustraliandollarfuturesMarch2011contractbid/askvalues

Thebid/askpricesandspreadaremoretransparentinthefuturesmarketthaninthe spot forex market because the same prices are essentially available toeveryoneastheyaretradedonaregulatedexchange.Futuresbrokersactonlytoreceive and execute orders for their clients. They do not act as principals ordealers in theway theydo in thespot forexmarket,asdiscussed inchapter5.Futuresbrokersdonotaddamarginormark-uptothequotedpricesanddonotwidenoralterspreads—theysimplyexecuteordersonbehalfoftheclientandchargeacommissionfortheprovisionofthisservice.Theydonottradeinthemarket as principals but as agents for their clients. Futures trades can beexecuted through a broker towhomyou give verbal instruction to transact onyour behalf, or on an electronic trading platform, where you place tradesyourself.

Futuresbrokersaregovernedbytherulesoftheregulatedexchangesonwhichfuturescontractstrade,andregulationsareenforcedbyvariousgoverningbodiessuch as the National Futures Association (NFA) and the Commodity FuturesTradingCommission (CFTC), bothUSorganisations.TheChicagoMercantileExchange (CME)group also has an in-house self-regulatingmarket regulation

department thataimstomaintaina transparentandfairmarketplace.Currencyfuturesmarketshaveagreatdealmoreregulation,protectionandoversightthantheOTCspotforexmarket.TipSomemarketparticipantsarguethattoomuchregulationdetractsfromapuretradingenvironmentattheexpenseofmarket efficiency,whileothers claim thatmarketparticipantsneed rulesand regulations toprotectandensurestabilityandsafety.

MarginandleverageIn order to trade currency futures you need amargin accountwith a licensedfutures broker, who will direct orders to the exchange and transact on yourbehalf.Currencyfuturesaretradedonmargininordertomaximiseleverage,aswediscussedindetailforthespotforexmarketinchapter5.Withouttheuseofmargin, enormous amounts of cash would be required to participate in thecurrencyfuturesmarket.ThefacevalueoftheAustraliandollarcontract,aswehaveseen,isAUD100000.Byusingamarginaccount,wherearelativelysmalldepositislodgedandthebalanceborrowedfromthebroker,thebuyingpowerofouraccountsincreasesmarkedly.TipTheamountofmarginrequiredforeachfuturescontractisafunctionofvolatilityandisdeterminedandsetbytheexchangeclearinghouse.

The standard A$100 000 futures contract has, in late 2010, an initial marginrequirementofUS$3240.Thismeansthatinordertotradeonestandardcontractthebrokerwill requireaninitialmarginofUS$3240tobe lodged,or justover3percentofthefullvalueofthecontract.Thee-microfuturescontractrequiresaninitialmarginofUS$324,beingone-tenththatofthefullcontract.

Themarginlodgedbytheclientwiththeirbrokeristhenlodgedbythebrokerwiththeclearinghousetoinsuretheclearinghouseagainstanylossontheopenposition. This initial margin is also referred to as a security deposit orperformance bond. It is essentially a good faith deposit that indicates you arewilling and able to meet your obligations under the terms of the contract.Brokers are permitted to request higher margins from their clients than theminimums imposed by the exchange during volatile periods or if a client is

perceivedasacreditrisk.Brokersarenotallowedtoapplyamarginthatislessthantheminimumsetbytheexchange.TipTradingonmarginallowsus to leverageouraccounts toproducehigherratesofreturn thanwouldbepossiblewithouttheuseofleverage.Leveragealsomagnifieslosses.

Let’slookatanexampleofhowtradingonmarginaffectsprofitsandlosses.

Withsufficientcapitalinourtradingaccounttoopenatradeusingastandard,or full-sized, Australian dollar currency futures contract, an initial margindepositofUS$3240wouldbe required.Fromour earlier example, the trade isenteredlongat0.9867,andincreasesinvalueby1centor100ticksto0.9967.AtUS$10pertick,theprofitonthetradeisUS$1000.Thisrepresentsareturnofalmost31percentontheinitialmarginrequiredforthetrade,aswehavemadeUS$1000profitbyusing justUS$3240ofourowncapital.Without theuseofleveragethereturnwouldbe1percent—US$1000profitonaninvestmentofUS$100000.

Thedownsideof leverage, of course, is that it can serve togreatlymagnifylosses,particularlyfortheunwaryorover-eagertraderwhomisusesleveragebytaking on position sizes that are too large for their accounts. This will bediscussedinchapter9.

Ifthesametradehadfallenby100ticksto0.9767fromourinitiallongentrypriceof0.9867,wehaveincurredalossof$1000onthetrade,orminus31percentreturnonthecapitallodgedasinitialmarginforthetrade.

In addition to the initial margin required at the outset of a trade, a secondmargin called variation or maintenance margin is also required. Maintenancemarginispartoftheinitialmarginthatmustbemaintainedincashinthetrader’saccountwhile a trade remains open. It is generally a smaller amount than theinitialmargin.TipIf the cash balance in the trader’s account at their futures broker falls below themaintenance level, amargincallwillbeissued,requiringtheclienttoeitheraddmorecashtotheiraccountorliquidatetheopenposition.

Thenovationprocessandtheuseofinitialandmaintenancemargingohandinhand.Currency futures contracts are essentially paper transactions that do not

involvethesaleorpurchaseofanythingtangible.Theyarecontractsfordeliveryof the specified commodity or currency at a date in the future, and physicaldelivery cannot take place before the specified date. Therefore, no moneyactually changes hands between the buyer and the seller nomatter howmanytimes contracts are bought and sold before the delivery date. The novationprocess of the clearing house acting as counterparty allows contracts to beboughtandsold.Themarginrequirementinturnfacilitatesthenovationprocess,allowing traders to buy and sell contracts by lodging margin with theirfuturesbroker.

Asthepriceofthecontractrisesandfalls,allopenpositionsarere-valuedattheendofeachtradingdayinaprocessknownasmark-to-market.Ifyouhaveanopenpositionthatisinprofit,theclearinghousewillcredityouraccount.Ifyouhaveanopenpositionthatisinloss,yourtradingaccountwillbedebitedtomaintainthemarginrequirement.Ifthislossamounttotalsmorethanthebalancein cash in your account, a margin call will be issued. The whole process isseamlessandensuresthetransparentandefficientoperationoffuturestrading.

SpotforexandcurrencyfuturescomparedIn chapters 5 and 6,we examined the spot forexmarket in detail, and in thischapterwehavelookedatcurrencyfutures.Bothspotforexandcurrencyfuturesprovide retail traders with ameans to access and trade the rapidly expandingforex market 24 hours a day, five and a half days per week. Both haveadvantagesanddisadvantagesandwewillnowcomparethetwoinstrumentstohelpyoudecidewhichisthemoresuitablemarketforyoutotradein.

OTCversusregulatedexchangeSpot forex trades in a non-regulated over-the-counter (OTC) market, whilecurrency futures are traded on a regulated exchange. Spot forex has lessregulation and there is no central market place where buyers and sellers arematched. The main downside to the OTC market is the potential risk of

counterparty default. Currency futures trade on a regulated and centralisedexchange where the exchange clearing house novates all trades by acting asbuyer to every seller and seller to every buyer,which removes the risk of thecounterpartydefaulting.

LotsizesandspecificationsSpotforexcanbetradedinmicrolotsof1000,minilotsof10000,andstandardlots of 100 000 of the base currency, and multiples of these lot sizes. Thisprovides access to themarket to a huge array of traders,with large and smallaccount balances, and provides for a much greater degree of flexibility thancurrency futures. The spot forex market allows those with relatively smallaccount sizes to gain access to trading forex. Currency futures are traded instandard contract sizes of 100 000 and e-micro contracts of 10 000 of thebasecurrency.

Currency futures have a fixed delivery ormaturity date,when the currencyspecified in the contract must be physically delivered. Futures cannot bephysicallydeliveredbeforethisdate.Inthespotforexmarkettheinitialdeliveryperiod is two days after the trade date, but the ability to roll over an openposition at the close of each trading day effectively makes for a continuouscontract.

PipsandticksPipvaluesinthespotforexmarketvarywiththelotsizebeingtraded,providingtraderswithahugeamountofflexibilityinregardtomarketandriskexposureintermsof each trade and each account.A traderwith a very small account cantradeonemicrolotwithapipvalueofjust10cents.Astheaccountbalanceandthetrader’sexperiencegrow,thiscanbeincreasedtotradingperhapsfivemicrolots or 50 cents per pip. Once the account balance has increased further, thetradermaythenchoose to tradeonemini lotat$1perpip.Traderswith largeraccountswhoare inapositionto tradestandardlotswilldosoat$10perpip.Buttheymayalsochoosetotradesmalleramountstoreduceriskandexposureortoallowthemtotrademultiplepositions.Eitherway,spotforexisextremelyflexible when it comes to allocating trading capital and defining risk-

managementprocedures.

Currencyfuturesaresomewhatlessflexibleinthattheycanonlybetradedinmultiplesof theavailablecontract sizes,and the tickvaluesaredeterminedbythese contract sizes. The smallest contract available is the e-micro contract,whichhasaminimumtickmoveofUS$1,sotraderswithverysmallaccountsmaybepreventedfromusingeventhee-microfuturescontracts.TipTraderswhohavelargeraccounts—andarethereforeinapositiontotradestandardfuturescontracts—maychoosetousemultiplesofthesmallere-microstoprovideflexibilityinthemanagementoftheirriskandtheircapital.

Brokers,dealersandmarketmakersCurrencyfuturesaretradedthroughregisteredandlicensedfuturesbrokerswhoactasanagentfortheirclients.Theyacceptorderstobuyandsellfromclients,and execute these orders on the appropriate exchange. This may be donemanually, byplacing the order verballywith the broker, or through the use ofonlineelectronictradingplatformstoplaceorders.Brokerschargeacommissionfortheprovisionofthisservice,andthatishowtheymaketheirmoney.Thesecommissionswillvarybetweenbrokersandaregenerallynegotiabledependingonyourleveloftradingactivityandaccountbalance.

Inspotforextheseservicesareprovidedbyamarketmakeroranon-dealingdeskfirm,whobothactasprincipalonbehalfoftheclientintothelargerinter-bankmarket.Bothprovideonlinetradingplatformsthroughwhichclientsplacebuyandsellorders,orclientscanplaceordersverbally.Marketmakersgenerallydonotchargeacommission,butmayactascounterpartytotheirclients’trades,andmaywidenspreadsandrequoteprices,asawaytomaketheirmoney.Non-dealingdesk,ordirectmarketaccess,dealersmaychargecommission,buttheygenerally add a mark-up to the best bid/offer prices they receive from theirliquidityprovidersastheirmainmeansofgeneratingrevenue.

Asaresult,thepricespreadbetweenthebidandtheaskisgenerallynarrowerortighterthaninthespotforexmarket.Wehavediscussedhowthedealersandmarket makers in the spot forex market can use the bid/ask spread, and thevariousbid/askquotesbeingsuppliedtothemfromthelargebanks,towidenandmanipulate the spread and how, this can vary between dealing firms. In the

currencyfuturesmarket,whatyouseeiswhatyouget,asallbrokersandtradersseeexactlythesamepricequotesontheregulatedexchange.

LiquidityandtransparencyWithout doubt the volume traded on the spot forex market far outweighs thevolume of currencies traded using currency futures. This makes spot forex amarketplacewhere it isextremelyeasy toenterandexit tradesbecauseof thehuge volumes constantly being transacted. Average daily volumes in thecurrencyfuturesarealsogreatwhencomparedwithotherfinancialmarketsandsome commodities, but they are dwarfed by the volumes in the spot forexmarket,whichturnsoveraroundUS$4trillionperdayin2010.

Transparencyofpriceandvolumeisamajorfeatureofcurrencyfuturesthatisnot asavailable in the spot forexmarket, and is amajoradvantage for futurestraders.Beingabletoseethedepthofvolumeonthebidandask,theorderflow,and any outstanding orders provides a clear view as to the liquidity of thecontractandtheleveloftraderinterest.Beingabletoseedailytradingvolumesineachcurrencyfuturescontractontheexchangeprovidesvaluableinformationtotradersabouttheliquidityofeachcontractandthemarketasawhole.Tradersareabletoseetheactualbidandaskpricesandthevolumesbeingsoughtateachprice level, nomatterwhich broker or trading platform they are using— thisinformationisavailabletoalltradersatalllevels.

Incontrast,bidandaskvolumesanddailytradedvolumesareunavailableinthe spot forex market because there is no central exchange on which thisinformationcanbereportedandrecorded.Thedecentralisednatureof thespotforexmarket means that this information is not available for themarket as awhole. Any of this information available from one dealing firm would benowherenearcomprehensiveenoughtoreflectwhatcouldbehappeningintherest of the market. Due to the nature of the spot forex market and therelationshipsthatexistbetweenvariousdealingfirmsandbankswithintheinter-bankmarket,pricequotescanalsoshowadegreeofvariationamongdifferentretail dealing firms and their platforms. Market-maker pricing may also varyconsiderably from the real price of the underlying instrument depending onspreadcalculationsandpricerequotes.

TipInthecurrencyfuturesmarketasmallretailtraderseesexactlythesamepriceandvolumeinformationasahugehedgefund.

LeverageandmarginBoth spot forex and currency futures are traded using margin accounts andleverage, giving both groups access to large positions with the use of only asmall amount of capital. The amount of leverage available in the spot forexmarket is fargreater than incurrencyfutures. It ispossible to tradewithup to400:1leverageinspotforex.Theseliberalandfreelyavailableleverageratescanprovide the opportunity for spectacular gains— but also catastrophic losses.Currencyfuturesaretradedusingmuchlowerlevelsofleverage,generallyinthevicinityofaround33:1.Tradingfuturesgenerallyrequiresthelodgingofalargerinitial margin deposit than spot forex. To open a standard Australian dollarcurrency futurescontractcurrently requiresamargin requirementofUS$3240,whileastandardAUD/USDlotsizeinthespotforexmarketcouldtheoreticallybeopenedwithamarginofjustUS$250,usingleverageof400:1.TipThe lower level of immediately available leverage helps futures traders with their risk and moneymanagement.

It’sallaboutchoiceInchoosing to trade forex, the twomain instrumentsavailable to retail tradersarespotforexandcurrencyfutures—bothoffertheabilitytoparticipateinthemarketasaspeculatororhedger.Bothareuniquevehiclesofferingsimilaryetdistinctly different products for participating in the forex market. Individualtraderswillhavedifferingreasonsforchoosingoneovertheother,ortheymaydecide to use both in different circumstances and with different strategies ortradingmethodologies.Eitherway,itisimportantthatyouknowandunderstandtheworkingofthetwomarketstoallowyoutomakeaninformeddecision.

Chaptersummary

⇒CurrencyfutureshavebeenavailablesincetheirintroductionbytheChicagoMercantileExchange(CME)in1972.

⇒PricequotesareoftenreferredtoasbeingeitherEuropean-orAmerican-stylequotes,whicharebasedonhistoricaltradingconventionsthathavebecomeinternationallyacceptedstandards.ThesetermsreflectthepositionoftheUSdollarinthecurrencypair.

⇒Asidefromtheirusebytradersandspeculators,crossratesareimportanttocompaniesandotherentitiestradingonglobalmarketsthatdon’tneedexchangeratesinvolvingtheUSdollar.

⇒EmergingmarketcurrencyfutureshavebeendevelopedbytheCMEtoallowtraderstogainaccesstoexchangeratemarketsthattheyareotherwiseunabletotrade,suchastheChineseyuan,KoreanwonandRussianrouble.

⇒Byinterposingitselfbetweenthetwocounterpartiestoeverytrade,theclearinghouseguaranteesthateachtradewillbehonouredandsettledassetoutinthefuturescontract.Thisnovationprocessmeansthatbuyersandsellersdonotdealdirectlywitheachotherandexposethemselvestocreditandcounterpartydefaultrisk.

⇒Unlikethedecentralisedover-the-counterspotforexmarket,currencyfuturesaretradedonaregulatedexchange,suchastheCME,andothersthatproviderulesandregulationsfortradinginthesefinancialproducts.Asaresult,currencyfuturescontracts,likeallfuturescontracts,havestandardspecifications—contractsize,expiryordeliverydate,andminimumpriceincrementandcorrespondingvalue.

⇒Allfuturescontractshaveadefinedexpirydatewhentheymustbeeitherdeliveredorsettledincash,dependingonthetermsofthecontract.

⇒Currencyfutureshaveastandardcontractsizeexpressedinthebasecurrency.

⇒Futurescontractsindicatetheminimumpriceincrementthatcanoccur,whichisthetickvalue,orthesmallestvaluebywhichthevalueofthecontractscanchange.

⇒E-microcontractsareroughlyone-tenththesizeofstandardcurrencyfuturescontracts.

⇒Thebid/askpricesandspreadaremoretransparentinthefuturesmarketthaninthespotforexmarketbecausethesamepricesareessentiallyavailabletoeveryoneasthecontractsaretradedonaregulatedexchange.

⇒Tthetwomaininstrumentsavailabletoretailforextradersarespotforexandcurrencyfutures.

Chapter8:Macroeconomicsandhowitaffectsforex

Tradingforex,withitshighlevelsofliquidity,andtheconstantebbandflowofbuyers and sellers, iswell suited to theuseof technical analysis in itsvariousforms. Technical analysis and themany indicators, oscillators, levels, patternsandmovingaverages,combinedwithpriceaction,provideamultitudeoftradingsignalsfortheproficientandeffectivetrader.

Perhaps more than in any other market, a huge range of fundamentaleconomicparametersandeventsaffecttheforexmarket.Allforextradersneedto be aware of the data and economic indicators that impact on currencyexchangerates.Itisalsohandytohaveagraspoftheunderlyingstrengthsandweaknessesofthemajorglobaleconomies,andtohaveageneralunderstandingofwheretheyareintermsofthebroadereconomiccycle.Foreachofthemostcommonly traded currencies, its unique characteristics and specific economicdataandeventshavethemostsignificantimpactontheirvalue.

This chapter takes a broad look at some of the economic data, events andindicators that influencecurrencyvalues,andwhathappens tocurrencyvalueswhentheseeconomicindicatorschangeeitherunexpectedlyorinlinewithtraderexpectations. Economic data is released at set times and dates in theindustrialisedcountriesandthesedatesareknownwellinadvanceinmostcases,providingadegreeofcertaintytothereleaseofthisinformation.

TipThereisoftenagreatdealofanticipationandspeculationbytradersinthelead-uptothereleaseofdataonthespecifieddates.

Other fundamental events that can impact currency markets include financialcrises,politicaleventsandgeo-politicalupheavalsthatarerandomandcanoccurunannouncedatany time.Tradershavenowayofknowingaboutorpreparingfortheseunexpectedeventsandcanonlyreacttothemaftertheyhaveoccurred.

We have already looked at the close relationship between interest rates andcurrency values in detail in chapter 2, so this chapter will focus on the otherimportanteconomicindicatorsandeventsthatimpactdirectlyonexchangerates.

EconomictheoryThereareafewwell-knowntheoriesaboutwhatdeterminesexchangerates.Likeall economic theories, they work wonderfully well in the perfect world ofresearch and analysis, when the realities of trading, including expectation,anticipation,speculationandthevariousotheractionsandreactionsofhumans,areomittedfromthetheory.

PurchasingpowerparitytheoryPurchasingpowerparity(PPP)theoryisbasedonthenotionthatthepriceofaproduct in one country should be equal to the price of the same product inanothercountrywhenconvertedtoacommoncurrency.Itisalsoreferredtoasthe lawof one price—anyproduct traded onworldmarketswill sell for thesame price in every country when expressed in the same currency. If, forexample,alaptopcomputersellsforA$1000inAustraliathenitshouldsellforUS$900intheUnitedStatesiftheAUD/USDexchangerateis0.9000(US$900÷0.900=A$1000).

TipPPPisoftenreferredto,tongueincheek,astheBigMacindex.

The term Big Mac index is based on the global availability of Big Machamburgers,andthefactthatsimilarinputsofdomesticallyproducedingredientsareusedtoproduceaBigMac.Therefore,under thePPPtheorythepriceofaBigMachamburgershouldhavethesamebasecurrencypricetheworldover.

Ifthepricesofthesamegoodsareoutofalignment,thenthistheorymaintainsthattherelativevaluesofthecurrenciesshouldreturntoequilibrium.Achangeintherateofinflationshouldbeoffsetbyachangeintheoppositedirectionofthe exchange rate, for instance. If prices are rising because of inflationarypressures,thentheexchangerateshoulddepreciate.Ifpricesarefalling,thentheexchangerateshouldappreciate.

Therealityis,however,quitedifferent,asthePPPmodelmakesnoallowancefortransportationcosts,tradebarriers,taxesandvariationsinproductioncostsindifferentsectorsindifferenteconomies.Italsomakesnoallowanceforinterestratedifferentialsbetweencountries.

BalanceofpaymentstheoryThebalanceofpayments(BOP)isameasureofthepaymentsthatflowinandoutofacountry.Thecurrentaccountmeasurestradeingoodsandservices,suchas raw material exports and manufactured goods imports. The differencebetweenimportsandexportsisreferredtoasthetradebalanceorthebalanceoftrade. The capital accountmeasures flows ofmoney for financial transactionsandinvestment.

Balanceofpaymentstheoryholdsthatexchangeratesshouldalwaysreturntoanequilibriumlevelthatproducesastablebalanceofpayments.Forexample,atradedeficitthatoccurswhenacountryimportsmorethanitexportsneedstobeoffset by positive capital inflows so the current account and capital accountbalanceeachotherout.Therealityisthattheseinflowsandoutflowsareneverinperfectequilibrium,andotherfactors—suchasinflation,unemploymentlevelsandinterestrates—arealsodriversofexchangerates.

TipIfmoremoneyflowsintoaneconomythanoutofit,thecountryhasapositivebalanceofpaymentsoratradesurplusandthelocalcurrencywillappreciateinvalue.Ifmoremoneyflowsoutofaneconomythaninto it, the country has a negative balance of payments or a trade deficit and the local currency willdepreciateinvalue.

RealinterestratedifferentialtheoryThebasisofrealinterestratedifferentialtheoryisthatanation’sinterestrateisthe major determinant of exchange rate movements. Currencies shouldappreciateinvalueincountrieswhereinterestratesarerelativelyhighorrising,whilecurrenciesshoulddepreciateinvalueincountrieswhereinterestratesareloworfalling.

As interest rates rise, and the yield on the currency and other financialinstruments in that country becomes more attractive to traders and investors,theywillbuythecurrency.Thecurrencywillbeingreaterdemandandtheflowofcapitalintothecountrywillincrease.Oneofthekeypointsstressedintherealinterest rate differential model is the expectation of further interest rateincreases,and theeffect thiswillhaveon thestrengtheningof thecurrency.Ashift in interest rate policy by the country’s central bank that is expected tocontinueforafewyearswillhaveamuchgreaterimpactonthecurrencythanapolicyshiftthatisexpectedtobeinplaceforonlytheshortterm.

Thismodel puts great emphasis on capital flows and ignores the effects ofgeo-politicalandothercrisiseventsthatcanupsetthewaytradersandinvestorsreact towardshigh interest ratesas theonlydeterminantofacurrency’svalue.Whileitisquitelogicalintheoryforinvestorstogravitatetowardsinvestmentsthat offer the highest rate of return, there is also a higher degree of risk orperceivedrisk.Intimesofglobalupheavalanduncertainty,investorswillmoreoftenthannotshiftfundsawayfromhigherreturn/higherriskcurrenciesandintolowerrisk,lowerreward,safe-havencurrencies,suchastheUSdollar,JapaneseyenandSwiss franc,preferring the safetyof their fundsover thepotential forhigherreturns.

EconomicdataandindicatorsthataffectforeignexchangevaluesLet’snowtakealookatsomeofthemajoreconomicandotherindicators,and

theimpactthesehaveonforeignexchangemarketsandcurrencyvalues.Theseindicators can be divided into economic indicators, inflation indicators andemployment indicators.Wholebookshavebeenwrittenonthissubject,sothissectionprovidesjustanoverview.

Economic indicators provide a general overview of conditions within aneconomy, and paint the broad economic picture. They tend to be released atregular intervals, at known times and dates, allowingmarket players towatchandmonitor the impactanychangesin thevaluesof theseindicatorswillhaveoncurrencyvalues.

Inflation indicators measure rising prices with an economy. Most centralbanks will use monetary policy measures, such as raising interest rates, tocontrolinflation.Higherinterestrateswillgenerallyleadtoariseinthevalueofthe currency, so inflation is one of the most closely watched indicators. Theinflation rate is also used to deflate nominal (or current) interest rates to realvalues(currentratesadjustedfortheeffectsofinflation).

Employment indicators are a measure of the structural soundness andunderlying health of an economy.Low unemployment levels indicate a soundeconomy; high unemployment levels indicate a struggling or slow-pacedeconomy.

TipEmploymentindicatorsarelaggingindicatorsandareoftenthelasttoshowchangesinaneconomy.

Asacountrycomesoutofarecessionorperiodofslowereconomicgrowth,newjobs are slowly added and this often takes a while to reflect in employmentfigures.Ifacountrydropsquicklyintorecession,jobsmaybecutslowly,againtakingsometimetobereflectedintheofficialunemploymentnumbers.

Countless economic releases bombard forex traders, and it is easy to getcaught up in this endless stream of data and economic announcements.Economic releases can provide information on an event that has alreadyhappenedbasedonpastdata(calledalaggingindicator);ananticipatedeventinthe future based on past data (called a leading indicator); or an event that iscurrently occurring based on current data and information (called a coincidentindicator).

AstheUSdollarisstillthemostactivelytradedcurrencyintheworld,mosttraders have a keen interest in these indicators in the United States and theimpact they have on the value of the US dollar. We will look at the majoreconomic, inflationandemployment indicators indetail for theUSdollar, andthen take a quick look at some of the fundamental indicators that affect othermajorcurrencies.

EconomicindicatorsNineofthemostwidelywatchedandmonitoredeconomicindicatorsthathaveramifications for forex traders are discussed here: gross domestic product(GDP), balance of trade, industrial production, durable goods orders,constructionindicators,retailsales,theconsumerconfidenceindex,theInstitutefor Supply Management index and the Conference Board Leading EconomicIndex®.

GrossdomesticproductGross domestic product (GDP) is considered to be one of themost importantindicators of the health of an economy. It is a measure of all the goods andservices produced in an economy within a 12-month period. GDP is a goodmeasureoftheoverallsizeofaneconomyandisaneffectivewayofcomparingdifferent economies around the world. The GDP for the United States isestimated by the International Monetary Fund (IMF) to be just over US$14trillionin2009.Thenextlargestsingle-countryeconomyisJapan,whichhasaGDP of just over US$5 trillion. In comparison the GDP figure for AustraliaestimatedbytheIMFisjustunderUS$1trillion,andfortheEurozonemembers,overUS$16trillion.

TipGDPgrowthisdesirableasitindicatesthataneconomyisexpanding—consumersandgovernmentsarebuyingthegoodsandservicesbeingproducedbybusinesses—anditisusedasameasureofacountry’sstandardofliving.

TheUSGDPnumbersarereleasedbytheBureauofEconomicAnalysis(BEA)inthreereports.The‘AdvanceEstimates’reportisreleasedattheendofthefirstmonthafterthequarterforwhichthefiguresarebeingreported.Thisisfolloweda month later by the ‘Preliminary’ report, which contains more accurateinformation.ThefinalGDPnumberisthenreleasedattheendofthethirdmonthaftertheendofthequarterforwhichtheinformationisbeingreported.Currencytraderswatchthereleaseoftheadvanceestimatesclosely,asthesenumberswillindicate any changes occurring to the growth and overall health of the USeconomy.

AgenerallyacceptedruleofthumbisthatGDPgrowthwithinaneconomyissustainableoverthelongtermataround3percentperyear.Growthanyhigherthanthisoveranextendedperiodbeginstoaddtoinflationarypressures.Whileahighrateofgrowth indicatesagrowingeconomyandwillnormally lead toanincrease in thevalueof thecurrency, inflationaryexpectations alsohaveabigimpact. If market participants are fearful of an increase in inflation orinflationaryexpectations,thismayhaveanegativeimpactonthecurrency.

TipGDPnumbers are reported in current dollar values and constant dollar values.Constant dollar valuereportingallowsforcomparisonstobeeasilymadebetweenhistoricalperiodsasitfactorsouttheeffectsofinflation.

The GDP data provides a detailed look at the overall economic health of aneconomyasitaimstorepresentthevalueofeverythingwithinaneconomy.Asaresult it also contains other information that helps paint a picture of what isoccurringwithinsectionsoftheeconomy.Theseincludechangesingovernmentspending, private investment and personal consumption expenditure,which allindicate any rises and falls in spending and investment patterns, and in whatareasaneconomyisexpandingorcontracting.

BalanceoftradeThe balance of trade is often referred to as net exports or trade balance as itmeasuresthedifferencebetweenthevalueofexportsof,andinternationaltradein, all goods and services in a given period. A trade surplus occurs when aneconomyexportsmorethanitimports,whichisgenerallyconsideredfavourablefor an economy; a trade deficit, or trade gap, occurs when a country importsmore than it exports, which is generally considered unfavourable for aneconomy.As the largesteconomyin theworldbyGDP, theUSisbothahugeimportingandexportingnationthathasrunatradedeficitformanyyears.Whilethe amount of this trade deficit varies in linewith the performance of theUSeconomyandtheglobaleconomyasawhole,along-lastingtradedeficitaddstoforeigndebt,onwhichinterestmustbepaid.Thelongerandlargeratradedeficitremainsinplace,themoredetrimentaltheeffectonthecurrency.Traderswatchthebalanceoftradeforsignificantimmediatechangetothebalanceoftradeandtomonitorlong-termtrends.

IndustrialproductionIndustrial production is the total output of the manufacturing, mining andutilities sector of the US economy. Although this sector is only a smallcontributor toGDP, it is an importantmeasureof the strengthof theeconomybecauseitishighlysensitivetoconsumerdemandandinterestrates,whichflowthrough to thevalueof thecurrency.Strongconsumerdemand leads tohigherlevelsofproduction,andthusastrongeconomyandastrongcurrency.Weakorreducedlevelsofindustrialproductioncausedbyaslowinginconsumerdemandcanindicateaslowingeconomy,whichwillhaveanegativeimpactonthevalueof thecurrency. Industrialproduction isalsousedasameasureof inflation,ashigh levels of industrial production can indicate high levels of consumerspending,leadingtothepotentialforinflationandtheneedformonetarypolicyinterventiontoslowtheeconomy.

DurablegoodsordersDurablegoodsareproductswithalifespanofmorethanthreeyears.Examplesinclude motor vehicles, household appliances, furniture, computers andmachinery.Thisdataisimportantforforeignexchangemarketsbecauseitgivesagoodindicationofconsumerconfidence.Businessesandindividualconsumersaremorelikelytobuydurablegoodswhentheirconfidenceabouttheeconomyishigh. Ifconfidence isweak, thenpurchasesof these largergoods tend tobedelayed. A high number for durable goods orders, therefore, indicates apropensity for retail and industrial consumers to spend theirmoney, adding toeconomic growth and adding to the value of the currency. A low numberindicatesconsumersarenotconfidentandsonotspending,whichslowsgrowthandweakensthecurrency.

TipDurablegoodsordersisoneoftheearliestindicatorsoftheunderlyingconditionswithinaneconomy,asthis figurereflectsconsumer’scommitment tospendingmoneyonbig ticket items,which in turnaffectslevelsofmanufacturingactivity.

ConstructionindicatorsHousing has traditionally been the driving force behind theUS economy, andoftenleadsthecountryoutofrecession.Theseindicatorsareclassifiedintothreemajorcategories:

⇒housingstartsandpermits—thetotalnumberofnewhousingprojectsbeguneachmonth

⇒existinghomesales—salesofpreviouslyownedsinglefamilyhomes

⇒newhomesales—salesofnewlybuilthomesthathavenotbeenpreviouslyoccupied.

Construction indicators are cyclical and sensitive to the level of interest rates(mortgagerates)andthelevelofdisposableincome.Lowinterestratesandhighlevels of consumer confidence generally lead to increased new and existinghomesales.Lowinterestratesalone,however,maynotbeenoughtogenerateahigh demand for new housing. Lack of job security and aweak or strugglingeconomy will result in low rates of housing construction despite lowinterestrates.ThisreflectsthesituationintheUSin2009–10,wherehistoricallylowinterestrateshavefailedtostimulatehousingconstruction,becauseofhighunemploymentlevels,lackofjobsecurityandweakconsumerconfidence.

TipIntheUShousingstartsbetweenoneandahalfandtwomillionunitstendtoindicateastrongeconomy,whereas a figure of less than one million units suggests that the US economy is in, or headed for, arecession.TheUSCensusBureauandtheDepartmentofHousingandUrbanDevelopmentestimatedthattheseasonallyadjustedannualrateofhousingstartsinOctober2009was529000.

RetailsalesRetailsalesisanestimateofthesaleofalldurableandnon-durablegoodsintheUS.Personalconsumptionspendingaccounts formore than65percentof theUnitedStates’GDP,soretailsalesfiguresarewatchedcloselybyforextradersasanindicatorofwhatandhowmuchconsumersarespending,andasagaugeofconsumerconfidence.Ifconsumerconfidenceishighandtheeconomicoutlookhealthy,thesefactorswillbereflectedinstrongnumbersforretailsales,whichwill have a positive impact on the currency. Weaker numbers, indicating aslowingeconomyoramorecautiousoutlookbyconsumers,orboth,mayimpactnegativelyonthecurrency,asaneconomicslowdownmaybeimminent.Iftheretailsalesnumbergrowstooquickly,thendemandmayoutpacesupply,causingprices to riseandadding to inflationaryexpectationsand thepossibleuseofariseininterestratestoslowtheeconomy.If,however,theeconomyhasbeeninaperiodofslowergrowthandinflationisnotacauseforconcern,thenanincreaseinretailsaleswillbeseenasverybullishfortheeconomyandthecurrency.

ConsumerconfidenceindexThe consumer confidence indicator (CCI) is a monthly nationwide survey of5000differenthouseholdseachmonthintheUSthataimstogaugetheviewsofthe average consumer on the current state of the economy, as well asexpectationsforthefuture.ThreeseparatefiguresmakeuptheCCI:

⇒indexofconsumersentiment—howrespondentscurrentlyfeelabouttheircurrentfinancialposition

⇒currenteconomicconditions—howtheyfeelthegeneraleconomyisgoing

⇒indexofconsumerexpectations—howtheyfeeltheeconomywillbeinsixmonths’time.

TipThe consumer confidence index, or CCI, is a sentiment indicator that tends to be at the forefront oftrackingthebusinesscycle,asitrepresentswhattheaverageconsumeristhinkingandfeelingabouttheeconomy.

Itis,however,ahighlysubjectivesurveywitharelativelysmallsamplesizethatat times canbehighly influencedbyemotive issues, suchaspetrolprices andothermattersthatmaybepertinentatthetimethesurveyiscompleted.Marketwatchers and analysts tend to look at averages of the index over extendedperiods rather than the data for eachmonth. If consumers are happy and feeltheirstandardof living is improving, thiswillbereflected in thesurvey. If theCCI is rising in line with increasing retail sales and other consumer-drivenindicators,thenitisthesignofastrongeconomy.

InstituteforSupplyManagementIndexThe Institute for Supply Management (ISM) Index is a monthly index thatmeasures the activity of 300 nationwide purchasing managers in themanufacturing and industrial sectors. They are surveyed on their currentactivities,includingproductionlevelsandcapacity,inventorylevels,neworders,employmentandothermanufacturing-relatedactivities.Surveyparticipants areaskedaseriesofquestionstowhichtheycanonlyrespondinoneofthreeways:better,thesameorworse.Theseresponsesarethenusedtoconstructthesurveyresults and to compare them with responses from the previous month. Indexvalues above50 indicate expansionwithin the sector and theoverall economyoverthepreviousmonth,whilevaluesunder50indicateacontractingeconomy.Figures that come in abovemarket estimates and expectationswill result in arally in the price of the US dollar; the release of figures lower than marketexpectationswillresultinaselloffintheUSdollar.

Even though the US economy, likemost of themajor world economies, isnowaservice-basedeconomy, the ISMIndex is stillextremely important.Themanufacturing sector still plays a big role in the US economy, so theemploymentandprices-paidsectionsoftheindexprovidevaluableinformationonthelabourmarketandinflation.

TipTheISMIndexisconsideredaleadingindicatorbecauseitprovidesaviewofwhattheleadingindustrialandmanufacturingcompaniesarecurrentlydoingandanticipatedoinginthemonthsahead.

ConferenceBoardLeadingEconomicIndex®The Conference Board Leading Economic Index (LEI) is calculated by theConference Board, a non-government organisation, and is a leading indicatorthatcombinesmuchoftheinformationfromthesurveysandindexesconductedby various government and non-government organisations we have discussedpreviously.Itisacompositeindexthatcombinesinformationfrom10individualcomponents,whichisintendedtoprovideaninsightintowheretheUSeconomyisheadedseveralmonthsinadvance.Itisseenasasmoothedindexbecauseitisacombinationofthefollowing10components,whichremovesthevolatilityofanyoneindividualcomponent:

⇒averageweeklyhoursworkedinthemanufacturingsector

⇒averageweeklyinitialclaimsforunemploymentbenefits

⇒manufacturer’snewordersforconsumergoodsandmaterials

⇒indexofsupplierdeliveries—ameasureofthespeedofdeliveryofnewmerchandisefromsupplierstovendors

⇒manufacturer’snewordersfornon-defencecapitalgoods

⇒buildingpermitsfornewprivatehousing

⇒stockpricesbasedontheS&P500Index

⇒inflation-adjustedM2moneysupply—ameasureofthetotalamountofmoneyincirculationinaneconomy

⇒thespreadordifferencebetweenlong-termandshort-termgovernmentbondinterestrates

⇒consumersentimentindex.

Generallyspeakingan increase in thevalueof the index ispositivefor theUSeconomyandtheUSdollar,andadecreaseinthevalueoftheindexisnegative

fortheeconomyandthevalueoftheUSdollar.

InflationindicatorsThe economic indicators discussed earlier provide us with information ongrowth and changes within an economy. The inflation indicators discussedfollowingareusedtogaugethelevelofpricestabilitywithinaneconomy.

ConsumerpriceindexA consumer price index (CPI) is ameasure of the average price of consumergoodsandservicespurchasedbyhouseholdswithinaneconomy.Itmeasurestheaveragechangeinpricespaidforaconstantbasketofgoodsandservicesfromone period to the nextwithin the same area. It is compiled from a sample ofpricesforfood,shelter,fuel,clothing,transportationandmedicalservices.

ThepercentagechangeintheCPIisthemainmeasureforestimatinginflation,or price growth, within an economy and changes in the cost of living. RapidincreasesinthevalueoftheCPIindicateinflation;rapiddecreasescansuggesttheonsetofdeflation—adecreaseinthepriceofgoodsandservicesleadingtolowornoeconomicgrowth.EconomistsandothermarketanalyststendtofocusontheCPI-UfigureintheUnitedStates.TheCPI-Ufigure,orthecoreinflationrate,excludesfoodandenergycomponentsfromthemeasurement,asthesetendtobethemostvolatileandseasonalprices.

TheUSFederalReserve,likeallcentralbanks,closelymonitorstheCPIasitsmainindicatorofinflationwithintheeconomy.SuddenorunpredictedchangestotheCPIleadtosharpincreasesincurrencymarketvolatilityastradersreacttochangesintheCPInumberinanticipationofmovesbythecentralbanktokeepinflationundercontrol.

ProducerpriceindexThe producer price index (PPI) is a collection of indices that measure pricechangesbydomesticproducers,andhowtheproducers’costofmaterialscanbepassedontoconsumersintheformofhigherpricesfortheirfinishedgoods.ThePPImeasurespricechangesfromthebusinesssideasopposedtotheCPI,whichmeasurespricechangesfromtheconsumerside—whatbusinessesarechargingratherthanwhatpeoplearepayingforproducts.

The PPI records changes in prices in percentage terms over the previousrecording period for awide range of industries in theUS economy, includingmanufacturing,mining,agriculture,forestry,fishingandenergyproduction.Itisabroad-basedindicatorthatreflectschangesinproductioncostsacrossvirtuallythe whole US economy, providing a valuable insight into any inflationarypressures thatmaybe starting to build. If producers are payingmore for theirinputs,thesecostswillbepassedontoconsumers,whichinturnaffectstheCPI.

CommodityResearchBureauFuturesIndexTheCommodityResearchBureauFuturesIndex(CRBIndex)measureschangesinthepricesof17commoditiesactivelytradedonUSfuturesexchanges;thesecommoditiesarerawmaterialsorproductsthatareassociatedwiththebeginningstages of production. Prices of thesematerials are among the first to react tochangingeconomicconditions.TheCRBIndexisanearlyindicatorofchangesinthebusinessclimateandinflation.Theindexisalsoanactivelytradedfuturescontract, so tracking changes in the value of the index is simply a matter ofmonitoringchanges in thepriceof theCRBfuturescontract.ThecommoditiesincludedintheCRBIndexandtheirsub-groupweightingswithintheindexareshownintable8.1(overleaf).

Table8.1:componentsoftheCRBIndexandtheirweightingintheindex

The CRB Index makes it relatively easy to watch for changes in commoditypricesandinflationarytrends.

EmploymentindicatorsTheunemployment rate is a lagging economic indicator, as it tends to changemoreslowly thanmanyothereconomic indicators,particularlyduring timesofrecession.Onceaneconomiccontractionhascausedjobstobecut,itoftentakestimeforconsumerconfidence to returnbeforeold jobsare filledagainornewjobs created. Employment reports are of major importance to all financialmarkets,andtotheforexmarketinparticular,astheypaintaveryclearpictureof the underlying health of any economy.Decreasing unemployment signals astrong economy with a positive impact on the currency. Increasingunemployment signals a weaker economy with a negative impact on thecurrency. There are two main measures of employment in the US: non-farmpayrollsandtheemploymentcostindex.

Non-farmpayrollsNon-farmpayrolls(NFP)identifiesthetotalnumberofpaidworkers,excludingthoseworkinginagriculture,intheUSandmeasuresthenumberofjobsaddedor lost in the economy over the preceding month. NFP numbers are releasedmonthlybytheUSDepartmentofLabor,providinganongoingstatementontheunderlyinghealthoftheUSeconomy.Thefarmingsectorisexcludedfromthedata because of the seasonal nature of the industry, which would distort thenumbersaroundseasonalharvesttimeswhenworkersareaddedandthenlaidoffatthecompletionofharvest.

Ingeneral,anincreaseinemployment(decreaseinunemployment),measuredby an increase in the number of paidworkers, indicates businesses are hiringmoreworkersbecausetheyareexpanding.Morepeopleemployedmeansmoremoney to spend on goods and services produced by these businesses, fuellingeconomic growth, and so the spiral continues. A decrease in employment(increase in unemployment) indicates jobs are being lost as the economycontracts.Fewerpeopleemployedmeans lessmoney tospend, fuelling furtherjobcuts,andsothedownwardspiralcontinues.

Non-farmpayrollsisthemostcloselywatchedofalltheeconomicindicatorswehavediscussedbecauseoftheimpactjobcreationorjoblosseshaveontheeconomyasawhole.MuchofthisimportancecanbeconsideredpoliticalaswellaspurelyeconomicbecauseofthepressureontheFederalReserveandtheUSgovernment to maintain employment levels. Interest rate policies are alsoheavily influencedby the rateofemployment,with theFed less likely to raiseinterestrateswhenunemploymentlevelsarehighorrising.

As well as the overall number of jobs added or lost the NFP report alsoincludesdataon:

⇒theunemploymentrateasapercentageoftheoverallworkforce

⇒thesectorsthatareshowingincreasesordecreasesinlevelsofemployment

⇒averagehourlyearnings.

Average hourly earnings is important because if the same number of peopleremainemployed,butareearninglessmoneythroughworkingfewerhours,thenthisiseffectivelyanincreaseinunemployment.

TipRevisions of the NFP numbers can also move the currency markets in response to revised levels ofemploymentorunemployment.

EmploymentCostIndexTheEmploymentCost Index(ECI) isaquarterlyreport thatdetailschanges inthecostoflabourintheUS.Itisbothaninflationandanemploymentindicatoras it measures whether the cost of employment is rising or falling, thusmeasuringwageinflation.TheUSFederalReserveusesshiftsintheECIinitsdecisions to adjust interest rates. TheECI is awidelymonitored and reportedeconomic indicator that seldom makes headlines, despite its importance totradersandmarketanalysts.

ImportanteconomicindicatorsforthemajorglobaleconomiesIn keepingwith our discussion of the sevenmost highly traded and importantglobal currencies, we will now take a brief look at some of the importanteconomic indicators that affect the other six currencies. As interest rate,employment,inflationandGDPannouncementsforeacheconomytendtohavesimilar, if not the same, ramifications for each currencywewill only look ateconomicindicatorsthatareuniquetoeachcountry.

ImportanteconomicindicatorsfortheEurozoneAccording to the IMF, if theEurozonewasa singlecountry itwouldhave thelargesteconomybyGDPintheworld,surpassingtheGDPoftheUnitedStatesbymorethanUS$2trillion—thecombinedGDPofthemembercountriesoftheEurozone is in excess of US$16 trillion. The euro is also the second mostactively traded currency, and for that reason a number of economic indicatorsrelatedtotheEurozonearecloselywatchedbyforextraders.TheEurozonealsocontains four of the top 10 countries byGDP in theworld. It is important tomonitor these indicators for specific member countries, particularly the largeGDP countries of Germany and France, as well as monitoring them for theEurozoneasawhole.

ThenatureoftheEurozonemeansthatthereisarangeofeconomicclimates,from some of the world’s largest to some very small economies, which arecombinedtoproducetheheadlinefiguresfortheEurozoneasawhole.Forthisreason,emphasistendstobeplacedonthedataandfiguresforGermany,FranceandItaly,asthecombinedGDPofthesethreecountriesmakesupmorethanhalfthe GDP for the Eurozone as a whole. The GDP of the individual Eurozonemembercountriesisshownintable8.2(overleaf).

Table8.2:Eurozonecountriesandtheirgrossdomesticproduct(GDP),2009

Source:InternationalMonetaryFundworldeconomicoutlookdata2009.

Someof themost important economic indicators for theEurozone include theHarmonised Index of Consumer Prices (HCIP), German Ifo Survey, GermanZEW Survey, National Institute of Statistics and Economic Studies (FrenchINSEE),andPMI(PurchasingManagerIndexes).

HarmonisedIndexofConsumerPrices

Eachmembercountrymustprovideinformationonmorethan100indexesusedto calculate the Harmonised Index of Consumer Prices (HICP) as a monthlymeasurementofpricesandinflationacrosstheEurozone.Thesenationalfiguresareweightedbeforearrivingatthefinalaggregatefigure.TheHICPisreleasedaftertheCPIfiguresfortheindividualmembercountries.

TipTheHCIPis importantbecause it is thereferencepointusedby theEuropeanCentralBanktomonitorinflation.

GermanIfoSurvey

ThissurveyisconductedmonthlybytheIfoInstituteforEconomicResearchattheUniversityofMunich.Eachmonththesurveyqueries7000Germanfirmsonthecurrentbusinessclimateand theirexpectations for thenextsixmonths.AsGermany is the largest economy in the Eurozone, this survey is a significantindicatorfortheoveralleconomichealthoftheEurozone.Theindexusesabasevalueof100,whichrepresents theaveragebalance in theyear2000,whenthesurveybegan.The further themonthlyvalue isaway from100 thestrongerorweaker the sentiment,with positive readings indicating a strong economy andnegativereadingsindicatingaslowdown.

GermanZEWSurvey

ZEW is the acronym for the Centre for European Economic Research. Itconducts amonthly survey ofmore than 350 financial analysts from firms infinance, trading and investment, predominantly in Germany. The EconomicSentiment Indicator is the headline component of the survey and is based onanswers to the single question: ‘In themedium term (sixmonths) the overallmacroeconomicsituationwill:improvenochangeworsen/noestimation?’Theresulting figure is thedifferencebetweenpositiveandnegative responses.TheZEWisconsideredasoneofthemostimportanteconomicdatareleasesfortheEurozoneandtheresultsofthesurveyhaveasignificantimpactontheeuro.

NationalInstituteofStatisticsandEconomicStudies(FrenchINSEE)

Theinstitute’sFrenchBusinessSurveycovers4000Frenchfirmsacrossabroadspectrumofindustries,fromagriculturetomanufacturing.Firmsaresurveyedoncurrentandforecastoutput,inventorylevels,actualpricesreceivedorpaidovertheprecedingthreemonths,andestimatedpricesforthenextthreemonths.Thefigures are used to measure inflation and other variables within the Frencheconomy.WhileitisnotasimportantastheGermanIfoortheZEWsurveys,thefigureshelptopaintabroadpictureoftheEurozoneeconomyasawhole.

PMI(PurchasingManagerIndexes)

Similar to the ISM index in theUS, these indexesprovide a viewof businessconditionsacrosstheEurozone.ThePMIshowtheresultsofamonthlysurveyby the Institute of SupplyManagement of 5000 firms across theEurozone onfive main factors — new orders, production levels, employment conditions,inventory levels and supplier deliveries. Indices are calculated for sectors(manufacturing, retail, services), individual countries and the Eurozone. TheEurozone PMI is a composite number that provides a sense of the broaderoutlook across theEurozone for awide spectrumof businesses and economicconditions. A value above 50 indicates expansion, and a value below 50indicatescontractioninthesectors,individualcountries,orEurozoneasawhole.

Othereconomicindicators

Other economic indicators that are relevant to changes in currencyvalues, butdon’timpactasdramaticallyonforexmarkets,include:

⇒GermanConsumerConfidence

⇒EurozoneEconomicSentimentIndicator(ESI)

⇒Eurozoneretailtradefigures

⇒Eurozonetradebalance

⇒GermanandEurozoneindustrialproduction.

ImportanteconomicindicatorsforJapanJapanisthesecond-largestcountrybyGDPandalargeexportingnation,andithasthethirdmostactivelytradedglobalcurrency.SomeoftheuniqueindicatorsfortheJapaneseeconomythatforextradersneedtobeawareofaretheTankanSurvey,thetradebalanceandtheIndustrialProductionindex.

TankanSurvey

The Tankan Survey is conducted by the Bank of Japan, the country’s centralbank,fourtimeseachyearonaround9000Japanesefirms.ItprovidesvaluableinsightsintotheoveralleconomicoutlookfortheJapaneseeconomy,includingthebusinesssectoroutlookoncapitalexpenditure,pricesandemployment.

TipTheTankanSurveyisusedbytheBankofJapaninformulatingitsmonetarypolicyandiswidelywatchedandanticipatedbyforextraders.

Tradebalance

As Japan’s economy is highly export driven, the balance of payments and thetradebalancenumberscanprovideavaluableinsightintoanychangesoccurringwithin the Japanese economy. A surplus trade balance indicates capital isflowing into Japanas foreignconsumerspurchase Japaneseexports; thishasapositiveimpactontheyen.AtradedeficitindicatesexportshaveslowedandthatJapanisimportingmorethanitisexporting,whichwillhaveanegativeimpacton thevalueof theyen.Themonthlymerchandise tradebalance that excludesservices is a more accurate measure of Japan’s visible trade in cars andelectronicsinexchangeforrawmaterialtomanufacturethesegoods.

IndustrialProductionIndex

TheIndustrialProduction(IP)IndexmeasureschangesintheoutputofJapanesedomesticmining,manufacturingandutilitycompaniesanddoesnotincludeanydata on imports. It is an index of domestic production for sales either withinJapan or for export and provides a view on Japanese domestic economicconditions.

OtherindicatorsforJapan

Otherrelevanteconomicindicatorsforforextradersinclude:

⇒Japanesetertiaryindustryindex

⇒leadingeconomicindex

⇒monthlyretailtradeindex

⇒BankofJapanmonthlyreport

⇒householdspending.

ImportanteconomicindicatorsfortheUnitedKingdomThe British pound is the fourth most actively traded currency, and it has acheckered relationshipwith theeuroand theEurozone.Someof the importantindicators for the UK and the British pound are the trade balance, industrialproductionandnewhousingstarts.

Tradebalance

As one of the largest components of theUK’s balance of payments, the tradebalanceprovidesaviewof thedifferencebetweenBritishexports and importsandanyimpendingchangestothepoundasaresultofatradesurplusordeficit.Thenon–EuropeanUniontradebalanceprovidesdetailsofBritain’s tradewithcountriesoutsideEuropeandhowcurrencypairstradingagainstthepoundmaybeaffectedbychangesinthetradesurplusordeficit.

IndustrialProductionIndex

TheIndustrialProduction(IP)Indexmeasureschangesindomesticoutputfrommining, manufacturing and energy companies for domestic and export use,which represents around a quarter of Britain’s GDP. It is a well-recognisedindicator formeasuring the levelofdomestic industrialactivity.Highor risingfigures indicate increased production, leading to economic expansion, whichbenefitsthepound.Over-productionmayalsoindicatethepotentialforinflation,whichwillhavenegativeeffectsonthepound.

Newhousingstarts

Like many Western economies the housing market is a key driver of theeconomy in the UK, so changes to the numbers of new houses being builtprovideaninsightintotheunderlyinghealthoftheeconomy.

OtherindicatorsfortheUnitedKingdom

OtherindicatorstowatchfortheUKinclude:

⇒retailsales

⇒nationwideconsumerconfidence.

ImportanteconomicindicatorsforAustraliaAsamajorexporterofrawmaterialsandimporteroffinishedgoods,thebalanceof trade figures are particularly important to the Australian economy and thevalueoftheAustraliandollar.Bothretailsalesfiguresandthetradebalancearewatchedcloselybyforextraders.

Tradebalance

As themeasure of the difference between exports and imports, this figure hasparticular importance for the Aussie dollar. When exports are greater thanimports and the Australian economy is in trade surplus, the Australian dollarincreasesinvalue.Whenimportsaregreaterthanexportsandtheeconomyisina trade deficit, the Australian dollar decreases in value. As a result, theAustralian dollar tends to have an inverse relationship with other majorcurrencies, rising when they are falling as exports increase and often fallingwhentheothermajorsarestrongandexportsfalloff.ThedemandforAustralia’srawmaterials to fuelglobal economicgrowthalso sees theAussiedollar rallywhendemandforcommoditiesandotherrawmaterialsishigh.

TipForextraderswatchtheAustraliantradebalanceandothertrade-relatedfigurescloselytomonitoranychangesinexportsandimports.

Retailtrade

This is a measure of all sales of goods and services by retail outlets withinAustralia. It is an important measure of consumer spending patterns andimpendinginflationarypressureswithintheAustralianeconomy.Steadilyrisingretail sales will also lead to greater imports tomeet demand, with a negativeimpactonthebalanceoftrade.

OtherindicatorsforAustralia

OtherindicatorstowatchfortheAustralianeconomyare:

⇒WestpacConsumerConfidencesurvey

⇒newmotorvehiclesales

⇒HousingIndustryofAustralianewhomesales.

ImportanteconomicindicatorsforSwitzerlandWithasmallpopulationandlimitednaturalresources,foreigntradeisimportanttotheSwisseconomy,sothetradebalanceisacloselymonitoredfigure,asitisinallindustrialisedeconomies.TheSwissfrancisalsoconsideredasafe-havencurrency during turbulent economic times. The UBS Consumption Indicator(compiledby theSwiss investmentbankUBS)andretail salesarewatchedbyforextraders.

UBSConsumptionIndicator

Thismonthlyindicator iscalculatedbycombiningtheresultsofnewcarsales,overnight hotel stays within Switzerland by Swiss nationals, credit cardtransactions, a consumer sentiment indexanda retail trends index.The resultsare combined into an index that is used to gauge the strength of domesticdemandandthehealthoftheSwisseconomy.Arisingvalueindicatesincreasingconsumer spending, leading to economic growth, while a decrease tends tosignalacontractionintheeconomy.Arapidriseintheindexalsosignalsrisinginflationarypressures.Thevalue is alwayspositive so thecurrentvalueof theindex is comparedwith thepreviousmonth’svalues, aswell as the short-termandlong-termaveragevaluestomonitorchanges.

Adjustedretailsales

Because private consumption is a large component of SwissGDP, retail salestend to be a leading indicator for the Swiss economy. Increasing consumerspending may indicate impending inflationary pressures, which will have anegativeimpactontheSwissfranc.

ImportanteconomicindicatorsforCanadaCanada is a commodity-and export-driven economy with the world’s seventhmostactively tradedcurrency.Forex tradersmonitoranumberof trade-relatedeconomic indicators for the Canadian dollar, particularly the InternationalMerchandiseTrade,IveyPurchasingManagersIndexandretailsales.

InternationalMerchandiseTrade

International Merchandise Trade (IMT) reports on the difference betweenimportsandexportsoftangiblegoods,suchasoil,goldandmanufacturedgoods,whicharesomeof themajorcontributors toCanada’sGDP.IMTfiguresdifferfromthetradebalancebecausetheydon’tincludeintangiblesorservices.AtradesurplusindicatesfundsareflowingintotheCanadianeconomyandcontributingto the appreciation of the value of the Canadian dollar, while a trade deficitindicatesfundsareflowingoutoftheCanadianeconomy,whichwillgenerallydepreciatethevalueoftheCanadiandollar.

IveyPurchasingManagersIndex

Across Canada, 175 corporate executives respond monthly to the IveyPurchasingManagersIndex(PMI)surveyquestion:‘Areyoupurchasinghigher,the same, or lower than the previous month?’ Responses are collated into anindex where a number above 50 indicates an increase in purchases over thepreviousmonth(expansionoftheeconomy),andanumberbelow50indicatesadecreaseinpurchasesfromthepreviousmonth(contractionoftheeconomy).

The PMI is a measure of optimismwithin the business community and anindicatorof economicgrowth. If firmsare increasingpurchases in response toincreaseddemandfortheirgoodsandservices,thentheeconomyisexpanding.Ifthisisreflectedinanoptimisticoutlook,thenitisagoodindicatorofexpectedfutureeconomicconditions.

Retailsales

Thisreportisadirectmeasureofconsumerconfidenceandisaleadingindicatorfor most Western economies. If consumers are spending more it indicatesconfidenceand theprospectof increasedfuturegrowth,withapositive impacton the economy and the currency. If consumer spending is contracting, itindicates lower levels of confidence and the prospect of slower economicgrowth,withnegativerepercussionsforboththeeconomyandthecurrency.

OtherindicatorsforCanada

OthereconomicindicatorstowatchforCanadainclude:

⇒buildingpermits

⇒housingstarts

⇒newmotorvehiclesales.

TipMoreoftenthannot,marketsanticipatethefiguresthatwillbeannouncedbeforetheactualreleaseofthenumbersforanyoftheseeconomicindicators.Asaresult,reactionsandpricemovementsaretriggerediftheannouncedfiguresarenotinlinewiththeseexpectations.

Chaptersummary

⇒Ahugerangeoffundamentalparametersandeconomiceventsaffecttheforexmarket.Itisimportantforallforextraderstobeawareofthedataandeconomicindicatorsthatinfluencecurrencyexchangerates.

⇒Purchasingpowerparity(PPP)isbasedonthetheorythatthepriceofaproductinonecountryshouldbeequaltothepriceofthesameproductinanothercountrywhenconvertedtoacommoncurrency.

⇒Thebalanceofpayments(BOP)isameasureofthepaymentsthatflowintoandoutofacountry.Thecurrentaccountmeasurestradeingoodsandservices,suchasrawmaterialexportsandmanufacturedgoodsimports.Thedifferencebetweenimportsandexportsisreferredtoasthetradebalance.Thecapitalaccountmeasuresflowsofmoneyforfinancialtransactionsandinvestment.

⇒Thebasisofrealinterestratedifferentialtheoryisthatanation’sinterestrateisthemajordeterminantofexchangeratemovements.

⇒Economicindicatorsprovideageneraloverviewofconditionswithinaneconomy,andpaintabroadeconomicpicture.Theytendtobereleasedatregularintervalsatknowntimesanddates,allowingmarketplayerstomonitortheimpactanychangesinthevaluesoftheseindicatorswillhaveoncurrencyvalues.

⇒Inflationindicatorsmeasurerisingpriceswithaneconomy.Mostcentralbankswillusemonetarypolicymeasures,suchasincreasinginterestrates,tocontrolinflation.Higherinterestrateswillgenerallyleadtoariseinthevalueofthecurrency,soinflationisoneofthemostcloselywatchedindicatorsforforextraders.Theinflationrateisalsousedtodeflatenominalinterestratestorealvalues.

⇒Employmentindicatorsareameasureofthestructuralsoundnessandunderlyinghealthofaneconomy.Lowunemploymentlevelsindicateasoundeconomy,whilehighunemploymentlevelsindicateastrugglingorslow-pacedeconomy.

⇒Grossdomesticproduct(GDP)isconsideredtobeoneofthemostimportantindicatorsofthehealthofaneconomy.

⇒Durablegoodsordersisoneoftheearliestindicatorsoftheunderlyingconditionswithinaneconomy,asitreflectsconsumercommitmenttospendmoneyonbigticketitems,whichinturnaffectslevelsofmanufacturingactivity.

⇒HousinghastraditionallybeenthedrivingforcebehindtheUSeconomyandoftenleadsitoutofrecession.

⇒Aconsumerpriceindex(CPI)isameasureforestimatingtheaveragepriceofconsumergoodsandservicespurchasedbyhouseholdswithinaneconomy.Itmeasurestheaveragechangeinpricespaidforaconstantbasketofgoodsandservicesfromoneperiodtothenextwithinthesamearea.

⇒Theunemploymentrateisalaggingeconomicindicator,asittendstochangemoreslowlythanmanyothereconomicindicators,particularlyduringtimesofrecession.

Chapter9:Moneymanagementforforex

As for all trading endeavours in all markets, the most critical yet most oftenoverlookedcomponentismoneymanagement.Alltoooftentradersarefocusedon the next great entry technique, thewhiz-bang new indicator or some otherapproach that isset tomake themasuccessfulandwealthy trader.Andall toooften thisends in tears,because they take risks thatare toobig for themoneytheyhave,havenotplannedforalosingstreak,havenotacceptedthefactthatthey will have losing trades, and do not understand the full implications oftradingonmarginusing leverage,asdiscussed inchapter5. In thischapterwewilldelve intomanyof theconcepts involved in riskmanagement andmoneymanagement in general, andmore specifically how they can be applied to thespotforexmarketwithitsuniqueleverageopportunities.

Notalltradeswillbewinnersandmanywillbelosers.Ifwedon’tacceptthisfact then we are doomed to fail in the markets. To be successful as a traderrequiresanacceptanceofbeingaloser,sometimesonseveraloccasionsinarow,whentradesgoagainstus.TipThe broad subject of money management can be broken down into three main areas — capitalpreservationandgrowth;thesettingofstoplosses,andtheuseoftrailingstopsorprofittargetsorboth;andposition-sizingtechniquestoensureappropriateuseandmanagementofleverageandmargin.

SwingingforthefencesThefirststeptowardsbecomingasuccessfulandprofitabletrader,andbuildinga solid foundation from which to approach the markets with a sound moneymanagement plan, is setting realistic expectations in terms of time, profit andreturnoncapital.Alltoooftenpeopleenteringthemarkets,andinparticularthespot forex market, expect to become profitable and successful traders withinaboutthreeweeks,withastartingaccountbalanceoflessthan$10000.Ahugenumber of people— on the internet and in othermedia sources, and throughsome trading education companies, andprovidersof unverified signal services

—claimtheyhaveturnedsmallamountsofcapitalintohundredsofthousands,even millions, of dollars. While some of these claims may well be realistic,many are not. Unfortunately people are tempted into the markets by theseclaims,orsetouttoemulatetheseclaims,onlytofindthatinthevastmajorityofcasestheclaimsbeingmadearesimplyunrealistic.Insomecasesthefiguresandresults have been fabricated and are unsubstantiated, and the claimed resultscannot be verified. In other cases the resultsmayhavebeen achieved, but thestartingcapital required toachieve theclaimed results isbeyond the realmsoftheaverageretailtrader.

Plenty of traders do consistently achieve returns that are well above theaverage levels of returns that investors have come to expect from the equitymarketsandother,morepassive,investmentfields.However,thesepeoplehavebeentradingforconsiderableamountsoftimeandhavedevelopedanenormousamountofexperienceandskill throughlonginvolvement in themarkets.Mostconsistently successful traders are not overnight sensations; instead they arelong-termsurvivorswhouseadisciplinedapproachandastrictsetofrulesfortheir trading, which they adhere to without fail. They employ strict moneymanagementrulesthatallowthemtomaximisereturnsfortheirtime,effortandcapital.Theyarenotlookingforonewinningtradewheretheyhavethrownalltheir tradingcapitalandmiraculouslyachievedawinning trade thatwill allowthem to retire to a secluded island paradise by 5 pm next Friday. Theyunderstandthattradingisagameofprobabilitiesinwhichtherewillbewinningandlosingtrades,winningstreaksandlosingstreaks,andperiodsofeuphoriaaswellasperiodsofgloom.Theyhaveatemperedapproachtoallofthevariablesthemarketcanthrowatthembecausetheyknowthatiftheypersevereandkeepfollowingtheir tradingandmoneymanagementrulestheywillachievesuccessandabove-averagereturnsoverthelongrun.TipSuccessfultradersarerealisticintheirexpectations.

Toooften,beginnertradersaresoldthestorythatwithastartingbalanceoflessthan$10000theywillbeabletoreplacetheirexistingweeklyincomeorbeabletofullysupportthemselvesfromtheirtradingactivitieswithinashortperiodoftime.That’snotlikelytohappen.

Let’s look at an example and assume that the average single person needs

about$40000per year to live a comfortable lifestylewith all bills able tobepaidwithoutanystressandhavesomeholidaysthroughtheyearaswell.Ifthisperson launches into a trading career, having quit their job, with a $10 000startingbalance,theyneedtoreturn400percentperyearjusttomaintaintheirlifestyle,andtheyhaven’tpaidanytaxyet!If theyalsowantedtoincreasetheamountofworkingcapital theyhaveavailableandgrowtheiraccountbalance,theyhave toachievewell inexcessof400percentperannumyearafteryearafter year. Compare this with a trader who begins trading with a $100 000accountbalance:thistraderhastoachieve40percentreturnperyeartomaintaintheir $40 000 per year lifestyle income, or someonewho starts outwith $200000 and requires a 20 per cent return to achieve the required $40 000 yearlyincome

Themain problem is that the traderwho starts outwith a small amount ofcapitalwillstart‘swingingfor thefences’—takingexcessiverisk,usinglargepositionsizesastheytrytoachievetheirgoal,hopingforoneortwotradesthatwillgetthemovertheline.Butinsteadofmakingwinningtrades,theyaremuchmore likely tosee theiraccounts fairlyquicklydecay toapointwhere it isnolongerviabletotrade.Table9.1showsthepercentagereturnrequiredtogetyourstarting capital back to its original level after a percentage capital loss. Ithighlightstheoftenoverlookedfactofhowharditactuallyistomakebackyourcapital,particularlyifyousufferasignificantlossofthatcapital.TipAninitialgoalforalltraderswhenstartingoutmustsimplybethepreservationofcapitalwhiletheylearnthenewskillsneededtobecomeasuccessfultrader.

Table9.1:percentagegainneededtorecovercapitallossintrading

If you start out with $10 000 and lose $6000 through poor or no moneymanagement, you have lost 60 per cent of your account. In order for you toreturnyouraccounttothe$10000youstartedoutwithyouneedtomakea150percentreturnonthe$4000leftinyouraccount.Putanotherway,youwillhavetobetwoandahalftimesmoresuccessfulinyourattemptstomakebackyourlossesthanyouwerewhenyoumadethelossesinitially—abigcall!

Many traders do not understand this concept of the importance of capitalpreservation. If you lose your capital you can’t trade any more. This lack ofknowledge andunderstanding causes them to go after ‘the home run trade’ astheyseektorapidlyexpandtheirtradingcapitalorstrivetoohardtoachieveanabove average returnon their capital.This lackof understanding causesmanytraderstotakerisksthataretoolargeforthesizeoftheiraccountandisoneofthemajorcontributingfactorsinthefailureofmanynewtraders.Muchofthiscanbeattributedtoalackofunderstandingoftheuseofstoplossesandtrailingstops to clearly define the amount of money that can be lost on every trade,before the trade is undertaken, and a lack of understanding of appropriateposition-sizingtechniquestoensurethattheamountofcapitalbeingputatriskon every trade is relative to the account size and the individual trader’s riskprofile.

Defininglosses

Tradersmust clearlydefine theamountof capital theyareprepared to loseoneachtrade.Whiletradersspendahugeamountoftimeandeffortdefiningtheirtradeentryrulesandrequirements,theyoftenoverlooktheconceptoftradeexitoratbestgive itonlyminorconsideration.Definingthepointatwhicha tradewillbeexitedseparatestherealtradersfromthepunters.TipKnowinghowtoacceptlosingtrades,throughtheapplicationofclearlydefinedexitrules,willgoalongwaytowardscontributingtoyourlong-termtradingsuccess.

Often referred to as cutting your losses, having clearly defined exit rules issimplyknowingwhenyouwilladmitthatatradeisnotworkingoutasplanned,acceptthatthemarkethasmovedagainstyou,andcutorexitthetrade.Itisallabout accepting defeat, accepting that on this occasion you are wrong, andmovingontothenexttrade.Thereisnopointhangingontolosingpositionsinthehopethattheywillturnaroundandmovebackinyourfavour.Thisnotonlytiesupyourcapital ina losingtrade thatyoucan’tput tobetteruse inanotherpotentiallyprofitabletradingopportunity,butalsowastesmentalenergyasyoustrugglewithwhattodowiththetrade,andspendprecioustimeagonisingoverwhen to do it. Far better to cut the losing trade early and unemotionally, andmoveontothenextpotentiallyprofitableopportunity—settingupastoplosswillallowyoutodothis.TipThepointatwhichatradewillbeexitedforaninitiallossisreferredtoasastoploss.Itisthepointatwhichtheamountofmoneywecanaffordtoloseonanytradeisreachedandthetradeiscutorexitedinordertostopanyfurtherlossofcapital.

Settingstop-losslevelsIn order towork effectively, stop-loss levelsmust be clearly defined for eachtrade before the trade is placed in the market. Every trade must be enteredknowingexactlywhere itwillbeexited if the tradegoes thewrongway.Thisprocessensuresweknowhowmuchmoneywearepreparedtoloseonatradeandthepriceatwhichthiseventwilloccur.Oncethatpricepointisreachedthetrade is exited immediately, either manually if you are executing the tradesyourself, or automatically if you are using is a fully automated mechanicaltradingsystem,withoutasecondthoughtoranyemotionalengagement.

Ifyouarewrong,moveon—thereisnopointtryingtohangontoalosingtrade toproveapointor toprove to themarketoranyoneelse thatyouknowwhatyouaredoing.No-onegetseverytraderighteverytime.Eventhegreatesttradersintheworldhavelosingtrades.Whatmakesthemgreattraders,however,is that they know they will have losing trades, accept their losses, and knowprecisely where these trades will be exited. This process allows them tocontinually probe themarket in search of profitable trading opportunities. Bycutting losing trades early, they are able to allocate the capital to anotherpotentiallyprofitable tradingopportunity, aswell as ridding themselvesof anyattachmenttotheoutcomeofanyonetrade.TipThenumber-onetradingruleistoalwaystradewithaninitialstoplossandplaceitwhenyouopeneverynewtrade.

Thelevelofstop lossescanbedeterminedinanumberofways,andyoumaywanttoresearchthemostappropriatemethodforyou.Somemethodsinclude:

⇒usingamaximumdollaramountexpressedasapercentageofyourtradingaccount.Ifyouhavea$10000account,forexample,youmaywishtoset,say,3percent,or$300,asthemaximumlossyouarepreparedtoacceptonanylosingtrade.Generally,thelargeryouraccountsize,thesmallerthisamountisinpercentageterms.Someonewitha$100000accountforexample,mayonlywanttorisk1percent,or$1000.

⇒usingchartpatternsandpricetoplacestoplossesunderneatharecentpricelowinthecaseofalongtrade,orabovearecentpricehighinthecaseofashorttrade.

⇒usingareasofsupport(priceareathroughwhichthecurrencypairisunabletomovelower)andresistance(priceareathroughwhichthecurrencypairisunabletomovehigher).

⇒usingvolatilitytodetermineappropriatestop-losslevelsfarenoughawayfromthecurrentpricetoallowthetradeadegreeoffreedomtomovearound,butnotsofarawaythatthestoploss,andthereforethelossofcapital,istoolarge.

⇒usingothertoolsorindicatorsthatyoumaydevelopovertime,fromyourownexperience.

Howmuchcapitalcanyouaffordtolose?The amount of trading capital you are prepared to lose on any one trade is amatter of personal preference and personal risk tolerance. Some people arenaturallymoreriskaverse,whileothershavehigherlevelsofrisktolerance.Thegenerally accepted norms in trading are that somewhere between 1 and 5 percentofyourtradingcapitalshouldbesetasthemaximumamountofyourcapitalyouarepreparedtoloseonatrade;mostbooksandtradingeducatorssuggest2per cent as the amount that a trader ‘should’ use. Risk-averse traders mightchoose a lower figure, while more risk-tolerant traders may be prepared toacceptagreaterlossinreturnforpotentiallygreaterreturns.

Factorsotherthanrisktolerancewillalsoaffecttheleveloflosschosen,suchastheaccuracyofthetradingsystemthetraderisusing,theprofitfactorofthesystemormethodologybeingused,andhowoftenthepersonis trading.Thesetopicsarebeyondthescopeofthisbook,butthereareanumberofothergreatbooks around that deal with these concepts in greater detail for those readersinterestedintakingtheirunderstandingoftheseconceptstothenextlevel.

Let’shavealookattheeffectsofdifferentpercentagelevelsusedfordefiningmaximum capital loss on a per trade basis. If three traders all started tradingforex with $10 000, all using the same trading system, their results will beradicallydifferentifonlytheamountofcapitaltheyarepreparedtoloseoneachtradeisvaried.TraderAchoosestoriskalossof2percent,or$200($10000×2percent),oneachtrade,TraderB,choosestoriskalossof4percent,or$400($10000×4percent),oneachtrade,andTraderCchoosestoriskalossof8percent,or$800($10000×8percent),oneachtrade.Let’sassumethattheyhave all attended a trading course and purchased a trading system ormethodologywithaproventrackrecordofsuccessandprofitabilityoverafour-yearperiod.WhatTraderChasfailedtograsp,however,isthatdespitethelong-termsuccessofthetradingsystem,ithasthepotentialtoincurastringorrunofup to six losing trades in a row, and in our example that is precisely whathappensafteraninitialwinningtrade.Theoutcomeisshownintable9.2.

As the table shows,TraderA,whohas a conservative approach to risk, haslost $666, or 6.66 per cent, of their starting capital; Trader B, who has amoderatelyaggressiveapproachtorisk,haslost$1295,or12.95percentoftheir

startingcapital:andrisk-takingTraderChaslost$2287orjustunder23percentof their trading capital.TraderCwill now require a 30per cent return just toreturntotheiroriginalstartingcapitalof$10000.

Our number one priority is the preservation of our trading capital.Withoutcapital to tradewith, we can’t participate in any trading activities— it’s thatsimple.Ofthethreetradersinourexample,TraderAhasclearlydonethebestjobofpreservingtheircapitalduringthestringoflosingtrades,ordrawdown,thatallthreetradershavejustexperienced.Havinglostonlyasmallpercentageof their tradingcapital, this trader iswellplaced tokeep trading thesystemorstrategyandtotakeadvantageofawinningrunorstringofwinningtradeswhenthey next eventuate. Having the discipline to keep trading and applyingconservativepositionsizing,TraderAwillhavealsomanagedtomaintaintheirconfidence in thesystem,accepting the losses incurredasanaturalpartof thetradingprocess.TraderC,ontheotherhand,islikelytobefeelingbeat-upbythemarket and wondering what the heck happened— and probably questioningboth the soundness of the system and their ability to continue to trade it.Psychologically,TraderA remains ingreat shape,whileTraderC is confused,dazed,andlookingforallthereasonstoexplainawaythefactthatpoormoneymanagementandpositionsizinghavecausedthelossofcapital.

Table9.2:effectofvaryingriskprofilesonlossofcapitalfromtrades

TipTheimportanceofsettingstop-losslevelsandclearlydefiningtheamountofcapitalyouarepreparedtoput at risk cannot be stated strongly enough. It is themost important concept in trading and one thatneedstobeinternalisedtothepointwhereitbecomessecondnatureforeverytraderseriousabouttheirsuccessinthetradingenvironment.

UsingleverageandpositionsizingLet’snowapplysomeoftheinformationwelearnedinchapter5,andlookattheuseofleverageintradingforex.Rememberthatleverageistheactofusingonlya smallportionofourowncapital andeffectivelyborrowing the rest from thebrokerordealertoincreaseourexposuretoafinancialmarket.

Readerswouldbefamiliarwithmanyofthepromisesofrichesadvertisedonthe internet and othermedia sources— ‘Start trading todaywith only $500’,‘Getupto400percentleverage’,andsoon.Whileit is truethatsometradershave startedwith relatively small tradingaccountsand turned them into largertrading accounts, the dream of becoming a millionaire overnight turns into anightmarewhentheoveruseandabuseofleveragewipesoutatradingaccount.Let’shavealookatwhythishappens.

Wewillseewhathappens to three traderswhohavealldecided to trade thesamesystem,andallhavethesame$10000startingaccountbalance.Theonlydifferenceistheamountofleveragetheydecidetouseandtheimpactthishasonthe size of their positions.We also assume for this example that of the threetraders,onlyTrader1understandstheimportanceofpositionsizingandmoneymanagement,andhaschosen to riskonly2percentof their tradingcapitaloneachtrade,despitethepotentialtoriskafargreateramountthroughtheleverageavailablefromtheirforexdealerfirm.Traders2and3,ontheotherhand,decidetousevaryingdegreesof the leverage available.Wewill also assume that thesystemortradingstrategybeingusedhasaproventrackrecordovermanyyearsandhundredsoftrades,butsuffersarunofsixlosingtradesinarowwhenthesethreetradersbegintheirquestforforextradingsuccess.Theresultsforthefirst10tradestakenbyourthreetradersareshownintable9.3,whichshowsthatallthreetradersmadealossof250pips.

Table9.3:traderesultsinpipsforallthreetraders

Trader1employsaposition-sizingmodel,asdiscussedearlierthatallowshimtoriskalossof2percentofhistradingcapitaloneachtrade.With$10000capitalavailablefortrading,thismeansariskof$200pertrade.Thesystemthetraderisusing sets a 100 pip stop loss to determine the point at which the trade hasobviouslynotworkedoutasanticipated,soTrader1cantradetwominilots(10000 units) or $2 per pip (100 pips at $2 per pip = $200). With a marginrequirementof1percent,Trader1needstolodgeabout$100ofhisowncapitalfor eachmini lot being traded ($10 000 × 1 per cent = $100). This providesleverageof100:1.Thetotalmarginrequirementof$200represents2percentofthe$10000tradingcapitalavailable.Trader1hasmakesaveryconservativeuseoftheleverageoffered,leveragingtheirtotaltradingcapitalinthiscasebyonly2:1—twominilotsof10000,or$20000:$10000oftheirowncapital.TipIt is important to understand thedifferencebetweenmaximum leverageoravailable leverageand trueleverage,andalsotounderstandtheleverageoneachtradeandtheleverageonyourtotalaccount.

Trader1hasusedleverageattherateof100:1forthetradeheisabouttoenterbyusing$200ofhis tradingcapitalas themarginon twomini forex lots (2×$10000mini lots=$20000at1percentmargin=$200).He isnowable totrade a $20 000 position by using $200 of his own money and effectively

borrowing the balance from his forex dealing firm. He is using the availableleverage rate of 100:1 on a per trade basis. His true leverage is, however,significantlylessthanthisashehasanopenpositionof$20000(twominilotsof $10 000 each) with a trading account balance of $10 000. The results forTrader1areshownintable9.4.

Despiteasix-tradelosingstreak,Trader1haslostjust$500or5percentofhistradingcapital.Thiswillrequirea5.3percentreturnforhimtorestorehisaccount balance to the initial amount. By adhering to the goal of capitalpreservation and using a conservative approach to risk management and aconservative use of the leverage on offer, he is still in the game and able tocontinuetoparticipateintheforexmarketinordertotakeadvantageoffurthertradeopportunitiesastheyarise.

Table9.4:traderesultsusing2percentriskforTrader1

Trader2ismuchmoreaggressiveinherapproachthanTrader1anddecidesthatbecause this is such a great system she is going to risk $1000 of her tradingcapital on each trade by trading one standard lot of $100 000 or $10 per pip.

Withamarginrequirementof1percent,shewilluse$1000ofherowncapitaland‘borrow’ thebalancefromthedealingfirm.She isstillusing theavailableleverageonapertradebasisof100:1,buthertrueleverageisnow10:1becauseshe has a $100 000 position with an account balance of $10 000. Her totalmargin requirement is 10per cent, as she is using$1000of her available $10000.By the time shegets to tradenumber8 (see table9.5, overleaf), the trueleverage has increased to around 18:1— her account balance has dropped to$5500yet she is still tradingonestandard lotof$100000 ($100000:$5500=18:1).Atthispointsheisalsoriskingapproximately18percentofheravailablecapitalon thenext trade($1000risk:$5500availablecapital).Her totalmarginrequirement is also18per cent, as she is using$1000ofher available$5500.Theresultsareshownintable9.5.

Table9.5:traderesultsusingafixed$1000riskforTrader2

After10trades,Trader2haslost25percentofheroriginalstartingcapital.Thiswillrequireareturnof33percentjusttorecoversoshecanbreakeven.

Trader3isusingthesamesystemandbelievesitwillbehissure-firerocketto

success in the forex market. He is excited about the profits the system cangenerate and is alreadyplanning thenewboat hewill buywith themoneyhewillgenerateinthenextfewweeks.Seeingonlytheupsideofthestrategy,andwithnoconceptofthepossibilityoflossormoneymanagement,hedecidestotrade threestandard lots.His true leverage is30:1 (threestandard lotsof$100000=$300000:$10000accountbalance)and theavailable leverage is100:1.Hisinitialmarginrequirementis30percent,asheisusing$3000marginofhisavailable$10000accountbalance.Theresultsareshownintable9.6.

UsingsuchanaggressiveapproachTrader3hasmanagedtocompletelywipeout his account and join the ranks ofmany otherwould-be forex traderswhomisusetheleverageofferedontheirmargintradingaccounts.WhileitlookslikeithastakensixtradestodestroyTrader3’saccount,tradenumbersixcouldnothave been taken. There is also the possibility that a margin call would haveoccurredduringtradenumber5whenthelossonthistradeexceededtheamountofmoneyleftintheTrader3’saccount.With$2500intheaccount,andamarginrequirementof$3000 for threestandard lotsat1percent, there isnotenoughmoneyleftintheaccounttocovertheinitialmarginrequirement.

Table9.6:traderesultsusingafixed$3000riskforTrader3

Although some readersmay think Trader 3’s case is an extreme example andunlikelytooccur,therearecountlessexamplesoftradersblowinguptheirforextrading accounts through similar scenarios. They usually result from a lack ofunderstandingoftheconceptsofmoneymanagementandlittleifanyknowledgeofthenegativeeffectsofthedualconceptsofleverageandmargin.

In theseexamples,positionsizeshavenotbeenadjusted inaccordancewithincreases and decreases in the account balance in line with prudent moneymanagementprincipals.Normally,positionsizeswouldbeadjustedupanddownin linewith the capital available, increasing as profits aremade and capital isadded to the tradingaccount, anddecreasingwhen losses are incurredand thecapital inthetradingaccountisreduced.Theyareshowntohighlight theneedforaconservativeapproachtobothriskmanagementandmoneymanagement,andtoensurethatreadersunderstandthedetrimentalaffectanoverlyaggressiveapproach to trading forex can have on your financial and psychologicalwellbeing.TipLeverageamplifies themovement in therelativepricesofacurrencypairby therateof leveragebeingused.Itmagnifiesbothprofitsonwinningtradesandlossesontradesthatmoveagainstus.

Let’ssayyoubuyonestandardlotofAUD/USDcurrencypairanditgoesupby1percentfrom0.9900to1.0000—againof100pipsor$1000.00(100pipsat$10 per pip). Table 9.7 shows how leverage would affect the return on themarginusedforthetrade.

Table9.7:howleveragemagnifiesgains

Ifthesametradegoesdownby1percentfrom0.9900to0.9801,leveragewillmagnifytheloss.Table9.8showstheresults.

Table9.8:howleveragemagnifieslosses

These examples highlight the magnifying effects of leverage on your tradingaccountandhowyoumustknowhowtomanageleverageandmanageyourrisktoavoiddestroyingyourforextradingaccount.

LeverageandsmallaccountsOne of the attractions of the leverage offeredwhen trading forex is that verysmallaccountscanusethisleveragetoachievehighlevelsofreturn.Aswehaveseen in the previous examples, the overuse and misuse of leverage can havecatastrophic results for uneducated and unprepared forex traders. Let’s have alook at a few examples of the effects of misusing leverage on these smallaccounts.

TraderJoeopensanaccountwith$500anddecidestotrademinilotsof$10000at$1perpip.Havingnounderstandingofthemoneymanagementprincipleswehavediscussedhere,hisfirsttradeistwominilotsofAUD/USD,withatrueleverage of 40:1 ($20 000 for twomini lots: $500 account balance).He does,however,placea30pipstoplossunderthetrade.The30pipstoplossisreachedandthetradebecomesa$60loser($1perpip×2minilots×30pipstoploss),reducing his account balance to $440. He has lost 12 per cent of his tradingcapital ($500– $440) and now requires a return of 14 per cent to recover hisstartingcapital.Annoyedbythisloss,TraderJoedecidestodoubleup,andbuyfourmini lots onhis next foray into the forexmarket, stillwith a30pip stoploss.Histrueleverageonthistradeis90:1(4minilots=$40000:$440accountbalance).Thistradeisalsoaloseranditcostshim$120($1perpip×4minilots×30pipstoploss),andreducinghisaccountbalanceto$320—intwotradeshehaslost36percentofhistradingcapitalandnowneedsareturnof57percenttoreturntohisoriginal$500startingbalance.Thenexttradeoftwominilotsisalsoa loser, reducing theaccountbyanother$60 toabalanceof$260—justover50percentoftheoriginalstartingamount.TraderJoenowneedsareturnof100percentjusttoreturntotheoriginalstartinglevel.

These examples illustrate how and why misunderstanding and misusingleverage is the killer for themajority of peoplewho attempt to trade forex. Ifharnessedcorrectly, leverageisapowerful toolthatcanmagnifyyourgains.If

notusedcorrectly,itwillwipeyouout.

Aswellaslearningeverythingyoucanaboutallaspectsoftheforexmarkets,capitalisingyouraccountsufficiently, tradingwithsensible leverage,andusingstrictmoneymanagementruleswillgreatlyincreaseyourchanceofsuccess.

Theuse of suitable rates of leveragewith proper account capitalisationwillensurelossesarekepttoaminimumandwillenableyoutoadheretothenumberonepriorityofcapitalpreservation.Combiningrelativelyconservativeposition-sizing techniques with the use of stop losses will allow you to manage yourtradesandyourtradingcapitalsoyoucansurvivethelosingtradesandremainsolvent and can continue to participate in the endless stream of tradingopportunitiesprovidedbytheforexmarkets.

Chaptersummary

⇒Thefirststeptowardsbecomingasuccessfulandprofitabletraderandbuildingasolidfoundationfromwhichtoapproachthemarketswithasoundmoneymanagementplanissettingrealisticexpectationsintermsoftime,profitandreturnoncapital.

⇒Mostconsistentlysuccessfultradersarenotovernightsensationsbutareinsteadlong-termsurvivorswhohaveadisciplinedapproachandastrictsetofrulesfortradingthattheyadheretowithoutfail.

⇒Forextradingisagameofprobabilitiesinwhichtherewillbewinningandlosingtrades,winningstreaksandlosingstreaks,andperiodsofelationaswellasperiodsofdisappointment.

⇒Toooften,beginnertradersaresoldthestorythatwithastartingbalanceoflessthan$10000theywillbeabletoreplacetheirexistingweeklyincomeorbeabletofullysupportthemselvesfromtheirtradingactivitieswithinashortperiodoftime.Therealityisdifferent.

⇒Preservingcapitalisyournumberonepriority:ifyouloseyourcapitalyoucan’ttradeanymore.

⇒Stoplosses,setatthestartofthetrade,definethepointatwhichyouwillexitatradethathasmovedagainstyouandlimityourlossestowhatyouhavedecidedyoucanaffordtorisk.

⇒Between1and5percentofyourtradingcapitalcanberiskedoneachtrade,dependingonyourpersonalriskpreferences,tradingsystemandnetworth.

⇒Leveragemagnifieslossesaswellasprofits:itisadouble-edgedswordthatneedstobefullyunderstoodandrespectedinordertoensureyourlongevityinthetradingenvironment.

⇒Successfultradershaverealisticexpectations.

GlossaryAmerican-stylequotesexpresstheamountofUSdollarsneededforoneunitofaforeigncurrency.TheUSdollar isquotedsecondandis thequoteorcountercurrency.American-stylequotesarealwaysquotedinUSdollarsandcents.

arbitrage taking advantage of price differences for the same instrument indifferentmarketstomakeaprofit.Forexample,apricedifferencebetweenthesamecurrencyinthespotforexmarketandthefuturesmarket.

askpriceorofferprice;thepricesellersarewillingtoacceptandthereforethepriceatwhichyoucanbuyacurrency.

atbestoratmarket;buyingorsellingatthecurrentmarketprice.

aussieaspecificforextraders’termfortheAustraliandollar.

balanceofpayments(BOP)ameasureofthepaymentsthatflowinandoutofacountry.Thecurrentaccountmeasurestradeingoodsandservices,suchasrawmaterial exports and manufactured goods imports. The difference betweenimports and exports is referred to as the trade balance. The capital accountmeasuresflowsofmoneyforfinancialtransactionsandinvestment.

basecurrencythefirstcurrencyquotedinanyforexpair.

bidorbuyprice;thepricebuyersarepreparedtopay,andthereforethepriceatwhichyoucansell.

big figure the whole dollar price of a quote without the decimal points. Acurrencypairtradingat109.43,forexample,hasabigfigureof109.

BigMac index a colloquial term for the purchasingpower parity theory. It isbasedontheglobalavailabilityofBigMachamburgersandthefactthatsimilarinputs of domestically produced ingredients are used to produce a Big Mac.UnderthePPPtheory,thepriceofaBigMachamburgershouldintheorybethesameinthebasecurrencypricetheworldover.

Bretton Woods Accord or system; established in 1944, towards the end ofWorld War II, to manage monetary and financial relations among the majorindustrial economies. It included the use of the gold standard to peg or fix

exchangerates,andtheestablishmentoftheInternationalMonetaryFund(IMF)and the International Bank for Reconstruction and Development (IBRD), orWorldBank,toencourageandoverseeglobaltradeandreconstructionafterthewar.

BRICeconomies the termused todescribe theemergingeconomiesofBrazil,Russia,IndiaandChina.

brokerafirmorindividualthatactsasanagentbetweenbuyersandsellers;theyarepaidacommissiononeverytrade.

capitalaccountmeasuresmoneyflowsintoandoutofaneconomyforfinancialtransactionsandinvestments.

capitalisationameasureofthesizeofafirmorbusiness.

carry trade buying a currency with a high interest rate and simultaneouslyselling a currency with a low interest rate. The interest rate paid on theborrowed,or sold, currency ismore thanoffsetby the interest receivedon theboughtcurrency.Profitismadeonthedifferencebetweenthetwointerestrates.

central bank or reserve bank; the principal monetary authority of a nation.Central banks are usually responsible for issuing currency, controlling interestrates,overseeingthecommercialbankingsystemwithinanation,andcontrollingthesupplyofmoney.

charting using price charts and technical indicators to arrive at trading andinvestmentdecisions.

Chicago Mercantile Exchange (CME) the regulated US futures tradingexchange.

closeapositionorcloseout;toexitanopentradeateitheraprofitoraloss.Ifyouhaveabought,orlong,openpositionyouwouldselltoclosetheposition;ifyouhaveashort,orsold,openpositionyouwouldbuytoclosetheposition.

consumerpriceindex(CPI)ameasureoftheaveragepriceofconsumergoodsand services purchased by households within an economy. It measures theaveragechangeinpricespaidforaconstantbasketofgoodsandservicesfromone period to the nextwithin the same area. It is compiled from a sample ofpricesforfood,shelter,fuel,clothing,transportationandmedicalservices.

core inflation rate (CPI-U) a measure of inflation that excludes food andenergycomponents,which tend tobe themostvolatile and seasonal.Seasonalfactors, such as drought, floods andother natural events, can cause short-termspikes in prices for these food and energy components of the index. If thesesharp, short-termprice increasesare included in the index, they tend to inflatethevalueoftheindexintheshortterm.TheCPI-Ufigureprovidesasmootherview of the inflation data, as it is not skewed or affected by these short termpricespikes.

countercurrency or quote currency; the secondcurrencyquoted in any forexpair.

crosscurrencypairalsoreferredtoascrossrateorcross;isanycurrencypairthat does not include theUSdollar on one side of the deal: examples includeEUR/JPY,AUD/JPY,GBP/AUD.

crossthespreadorcrossingthespread;buyingat theofferprice,orsellingatthebidpricetoenter(open)orexit(close)atrade.

currencyhedgetheactionoflockinginthevalueofthecurrencybybuyingorsellingatthecurrentpricetoavoidanyfurthermovementsinexchangerates.

currencypairsbasictoforextrading.Allcurrenciesaretradedagainstthevalueofanothercurrencyandsoarealwaystradedasapairinwhichthevalueofthebasecurrencyrisesandfallsinvaluewhencomparedtothequotecurrency.

currencyreserve(s) or foreign exchange reserves; amounts of various foreigncurrencyassetsheldbycentralbanks.

currencyswap(s) or swap(s); the simultaneous purchase and sale of identicalamountsofonecurrencyforanotherwithdifferentvaluedates.Theyallowthetwopartiesinvolvedintheswaptoexchangeaspectsofaloaninonecurrency(theprincipalandinterestpayments)forequivalentaspectsinanothercurrency.

currentaccount one of two components of a country’s balance of payments.Thecurrentaccount is the sumof thebalanceof trade, interest anddividends,andanyforeignaidinaneconomy.Asurplusindicatesanexpandingeconomy;adeficitindicatesacontractingeconomy.

dealer a retail forex firm that acts as principal, on your behalf, for your

transactionsintheinter-bankmarket.

dealingpricethepriceatwhichanorderisfilled.

deflationwhen a country’s annual inflation rate falls below zero, indicating ageneraldeclineinprices.

deliveredordeliveredagainst;whenafuturescontractishelduntilthecontractexpiry date, or delivery date,when the specified amount of the commodity orcurrencyspecifiedinthecontractmustbedeliveredtothebuyer.

deliverypricethepricespecifiedinafuturescontract.

derivativeanyfinancialsecuritywherethepriceisderivedfromthevalueofanunderlyingasset.

directmarket access (DMA) the electronic trading facilities that allow retailtraderstodealdirectlyintothemarket.

ElectronicBrokingServices(EBS)aninter-bankdealingplatform—EBSSpotDealingSystem—usedby themajorbanks andparticipants in the inter-bankforexmarket.

economic indicators provide a general overview of conditions within aneconomy,andpaint thebroadeconomicpicture.Economicindicators includeacountry’sgrossdomesticproduct(GDP)andbalanceoftrade.

emergingmarketcurrencypairscurrencypairsthatarenotassociatedwiththemajorcurrencycrossesfromthedevelopedeconomiesoftheworld.

e-micro forex future(s) a futures contract that is one-tenth (10 000 units) thesizeofastandardcurrencyfuturescontract(100000units).

employment indicators ameasure of the structural soundness and underlyinghealth of an economy. Low unemployment levels indicate a sound economy,whilehighunemploymentlevelsindicateastrugglingorslow-pacedeconomy.

enteratradetobuylongorsellshorttoopenaposition.

European-stylequotes express theamountofcurrency thatcanbeexchangedfor1USdollar.TheUSdollarisquotedfirstandisthebasecurrency.

Eurozone themember statesof theEuropeanCommunity thatuse theeuroas

theirsinglecurrency.

exchangeratemechanismasystemintroducedbytheEuropeanCommunityinMarch1979inpreparationfortheintroductionofthesingleeurocurrency.

exit a trade to sell out of an open long position, or buy back an open shortpositioninordertocloseatradeateitheraprofitoraloss.

exotic currency a thinly traded currency that is illiquid and trades in lowvolumes.Thebid/askspreadisusuallywiderthanforthemajorcurrencypairs.

facevaluethefullvalueofacontractorlot.

FederalReserveSystemtypicallyreferredtoastheFed;theUScentralbank.

fiatmoneysystemcurrency thathasno intrinsicvalueand isnotbackedbyacommodityor anyother storeof value.Fiatmoneyhasvalueonlybecauseofgovernmentregulation.

fiscal policy the use of taxation and government spending to influence themoneysupplyandtheeconomyofanation.

fixingdatethedateonwhichthedetailsofaforwardcontractorswapdealareset.

floating exchange rate or floating currency; any currency that has its valuedeterminedbytheforcesofsupplyanddemandintheforeignexchangemarketratherthanavalueimposedbythegovernment.

foreignexchangeseeforex.

forexanabbreviationfortheretailforeignexchangemarket.Otherabbreviationsareretailforex,FX,marginfx,spotfxandspot.

forwardcontract(s) alsodescribedas forwardoutrightsandcurrency forwardcontracts;referstoanynon-standardisedcontractbetweentwopartiestobuyorsell a specified amount of a currency at an agreed exchange rate (called thedeliveryprice)atanagreedfuturedate.

forwardpoint(s)theadjustmentfactorusedonaforwardcontractbetweenthecurrentvalueof thecurrencyand itsanticipatedvalueataspecific time in thefuture.

fractionalpipanextrapipaddedtocurrencypairsthatisone-tenththevalueofafullpip.

fundamentalanalysistheuseofeconomicdata,newsannouncementsandotherresearchtoarriveattradingandinvestingdecisions.

future(s)theshortenedformforafuturescontract(s),whichisalegallybinding,standardised agreement to buy or sell a standardised commodity or financialinstrumentofspecificqualityandquantityonaspecifiedfuturedeliverydateatagivenlocation.

goldstandardamonetarystandardwhereaunitofthecurrencyisexchangeableforaspecifiedamountofgold.Thegoldstandardisnolongerusedasthemajorworld currencies are free floating and have their values determined by supplyand demand on the world currencymarkets. The only exception is the Swissfranc,whichispartlybackedbygold.

governmentsecuritiesbonds, treasurynotesandotherdebtinstrumentsissuedbyagovernmenttofinanceitsborrowings.

gross domestic product (GDP) a measure of all the goods and servicesproducedinaneconomywithina12-monthperiod.GDPisagoodmeasureoftheoverall sizeof aneconomyand is aneffectivewayof comparingdifferenteconomiesaroundtheworld.

G10currencypairs the currencypairs that contain the currencies of theG10countries.

headlinefigure(s) themain number resulting from a report or survey and theone thatgrabs theattentionof tradersand themedia,andmakes theheadlines.Anexampleisthequarterlyconsumerpriceindex(CPI).

hedgeorhedging;seecurrencyhedging.

hittingthebidsellingatthebid,orbuy,price.

hittingtheofferbuyingattheoffer,orask,price.

Ifo Survey a monthly survey conducted in Germany that asks German firmsaboutthecurrentbusinessclimateandtheirexpectationsforthenextsixmonths.

inflationageneralriseinthepricesofgoodsandservicesinaneconomyover

time.SeealsoCPI.

inflationindicatorsusedtogaugethelevelofpricestabilitywithinaneconomy.Theyincludetheconsumerpriceindex(CPI)andtheproducerpriceindex(PPI).

InstituteforSupplyManagement(ISM)IndexamonthlyindexintheUSthatmeasures theactivityofnationwidepurchasingmanagers in themanufacturingandindustrialsectors.

inter-bankmarketthetradingofcurrenciesbetweenthelargebanksandotherfinancialinstitutions.

InternationalMonetaryFund(IMF)aninternationalorganisationofmembercountriesthataimsforcooperationonexchangeratesandothermonetaryissuesbetweenmembers.

International Money Market (IMM) developed by traders at the ChicagoMercantileExchange(CME)intheearly1970stoallowthemtotradecurrencyandinterestratefutures.

laggingeconomicindicatorssupplydataandinformationonaneventoreventsthat have already happened, usually some time after the event. Theunemploymentrateisanexampleofalaggingindicatorasitrespondsslowlytochangesthathavealreadyoccurredwithinaneconomyandtheinformationandnumbersareoftenreportedseveralmonthsafterthechangeshavealreadytakenplace.

lawofonepriceseepurchasingpowerparity.

leadingeconomic indicators attempt toanticipate futureeventsbasedonpastdata, so they tend tochangebefore theeconomychanges.Thestockmarket isoftenseenasaleadingeconomicindicatorasittendstobegintorisebeforeaneconomycomesoutofarecessionandbeginstoexpand,andoftenfallsinvaluebeforeaneconomygoesintoarecessionorperiodofeconomiccontraction.

leveragesometimesreferredtoasleverageup;theuseofmargintoincreasethesizeoftradesyouareabletomakebyborrowingfromyourdealingfirm.

limitorder anentryorder tobuyacurrencypairbelow theprevailingmarketpriceor tosellacurrencypairabove theprevailingmarketprice.Limitorderscanalsobeusedastakeprofitordersonceatradehasbeenenteredeitherabove

theprevailingmarketprice,foralongposition,orbelowtheprevailingmarketprice,forashortposition.

liquidity the volume of transactions. The more liquid a currency pair is, themore buyers and sellers are participating in themarket, and the easier it is toenterandexittrades.

longpositionorgoinglong;buyingacurrencypair inanticipationofafurtherincreaseinthepriceofthebasecurrency.

lotsizetheamountofaforexcurrencypairyoucandealin.Standardlotsarefor100000units;minilotsarefor10000units;andmicrolotsarefor1000units.

maintenancemarginorvariationmargin;themargin,oramountofmoney,thatyoumust have in your trading account to ensure youdo not receive amargincall.

majors the most commonly traded currency pairs, usually involving the USdollarononesideofthecurrencypair.

margin call when themark tomarket loss on a trade exceeds the amount ofmoneyinyourtradingaccount.Amargincallwillrequireyoutoputextracashinto your trading account or close a position or positions in order to ensuresufficientmarginismaintainedinyouraccounttocoverthemarginrequirementofanyopenpositions.

marketmaker(s)afirmintheretailforexmarketthatmaintainsbid/askpricesandiswillingandabletodealwithclientsatthesepubliclyquotedprices.Thesepricesmaynotalwaysreflecttheactualpricestradingintheinter-bankmarket.Amarketmakerwilloftentaketheothersideofaclient’strade.

marketorder(s) any order to buy or sell a currency at the prevailingmarketprice.

mark-to-market recordingthevalueofopenpositionsandtotalaccountvalueonadailybasistocalculateprofitsandlossesandmarginrequirements.

monetarypolicyusedbyacountry’scentralbanktocontrolthemoneysupplyinaneconomy,throughtheuseofinterestratepolicies.Monetarypolicymaybedescribedasexpansionaryorcontractionary,dependingon theeffect itaims tohaveontheeconomy.

moneysupplythetotalamountofmoneyavailableinaneconomyatanytime.

nakedinterventionorunsterilisedintervention;thedirectbuyingorsellingofacountry’s currencyby its central bank.Naked intervention leads to changes inthemoneysupply.

netexportsseetradebalance.

netpositionbalanceofallopenlongpositionsminusallopenshortpositions.

nominalinterestrate(s)thecurrentinterestrate,notadjustedfortheeffectsofinflation.

non-dealingdesk(NDD)firm(s)aretailforexfirmthatoffersdirectaccesstothemarketforclientsthroughelectronicdealingplatforms.Thefirmactsastheprincipalforaclientintheinter-bankmarket,butitdoesnottaketheothersideoftheclient’strades,inthewayamarketmakerwould.

non-deliverableforward(NDF)ashort-term,cash-settledcurrencytransactionthattakesplacedirectlybetweentwocounterparties.

novationtheoperationoftheclearinghouseinthefuturesmarketwherebytheclearinghouseassumestheroleofbuyeragainstthesellerandselleragainstthebuyer to ensure that the counterparties to a trade are never exposed to defaultriskbytheotherparty.

NYLONthespotforextradingtimeswhenbothLondonandNewYorkareopensimultaneously.

offerpriceseeaskprice.

officialdollarisationtheuseoftheUSdollarbyothercountriesasanacceptedformofcurrency,eventhoughtheyhavetheirowncurrency.

officialinterestratesinterestratessetbyanation’scentralbank.

offsettingaprocessusedbymarketmakerstoreducetheirriskinthemarketbybuyingtheequivalentamountofacurrencythataclientorclientsareshort,orsellingtheequivalentamountiftheyarelong.

openmarketoperation(s)thebuyingandsellingofgovernmentsecuritiesbyanation’s central bank in order to controlmoney supply and short-term interest

rates.

open long position a position bought in anticipation of future currency priceincreases.

openpositionanycurrenttradewherethetraderiseitherlongorshort.

openshortpositionapositionsoldinanticipationoffuturecurrencypricefalls.

over the counter (OTC) the direct trading of any financial instrument orsecurity between two parties, rather than through the use of a regulatedexchange.

pegrateorpegged(currency);operateswhenacurrency’sexchangerateisfixedtothevalueofanotherstronger,ormorewidelyaccepted,currency,suchastheeuroortheUSdollar.

percentageinpointseepip.

performancebond also called a securitydeposit; an initial good-faithdepositrequiredbyabrokerordealertoopenatradewhentheclientisusingamarginaccount.

petro-currencyatermusedtodescribetheCanadiandollarbecauseofitsclosecorrelationwiththepriceofoilandotherenergycommodities.

pip an abbreviation for percentage in point or price index point, and it is thesmallestpricemoveaspotcurrencypaircanmake.

producerprice index(PPI)ameasureof theaveragechange insellingpricesreceived by domestic producers within an economy. Previously called thewholesalepriceindex,itisanindexofwholesalepricechangesthatisseenasanindicatorofpotentialfutureretailpricechanges.

profittargetapredeterminedpriceatwhichyouwillexitatradeforaprofit.

purchasingpowerparity (PPP) the theory that the price of a product in onecountryshouldbeequaltothepriceofthesameproductinanothercountrywhenconvertedtoacommoncurrency.

quotecurrencyseecountercurrency.

real interestratedifferential theory the theory that anation’s interest rate is

themajordeterminantofexchange ratemovements. It suggests thatcurrenciesshouldappreciateinvalueincountrieswhereinterestratesarerelativelyhighorrising, while currencies should depreciate in value in countries where interestratesareloworfalling.

Repurchase agreement also called repos or sale and purchase agreements; acontractthatgivesthesellertherighttobuybacktheassetataspecifiedpriceanddate.Intheforexmarketreposareusedbydealersingovernmentsecuritiesonanover-nightbasis.Thedealersellsagovernmentsecurity,suchasatreasurybond,toaninvestor,withanagreementtobuyitbackagainthenextday.Reposare effectively a form of short-term borrowing for dealers in governmentsecurities.

requoteoccurswhentheoriginalpriceseenonthedealingplatformisamendedby themarketmakerbetween the timea trader’sorder isplacedandwhen theorderisfilled.

reservecurrencyanyofthemajorcurrenciesheldinalargequantitybycentralbanks and other financial institutions as part of their currency reserves.Traditionally, theUSdollar has been themajor global reserve currency, alongwiththeBritishpound, theJapaneseyenandtheSwissfranc.Theeuroisnowthesecond-largestreservecurrency.

reserverequirementorcash reserve ratio, isa requirement inmanycountriesthat commercial banks andother financial institutions that hold customer cashdepositsholdapercentageofthesedepositsandaccountbalancesondepositatthecentralbank.

restingorder(s) or a pending order; any stop or limit order that has not beenfilled yet at the price specified retail forex the electronic trading of foreignexchange through online dealing platforms with dealing firms and marketmakersbysmalltradersandspeculators.

Reutersaninter-bankdealingplatform.

reverserepoormatchedsale;whenthecountry’scentralbanksellsrepos.Theresult isatemporarydrainingoffundsfromthebankingsystem,whichpushesup interest rates and increases the price of the country’s currency on foreignexchangemarkets.

rollover or roll; means extending the settlement date of an open spot forexposition by closing an open position at the end of the day and immediatelyreopeningitattheopeningofthenextday.Rolloverisexecutedautomaticallyinyouraccountbytheforexdealingfirm.

safe-havencurrencyacurrencythatisperceivedbyinvestorstoofferstabilityduringtimesofeconomicorgeo-politicalcrisis.Favouredsafe-havencurrenciesincludetheSwissfranc,Japaneseyen,USdollarandeuro.

S&P 500 short for Standard & Poors 500, which is an index of 500 leadingstocksintheUS.

secondary currency a term sometimes used to describe the quote or countercurrency.

settlement date the date on which a contract must be settled in cash ordelivered.

share price index (SPI) a futures contract based on an index of stocks. InAustralia theSPI200futurescontract isbasedontheindexoftheleading200stocksontheAustralianSecuritiesExchange.

short selling or a short position; selling a currency pair in anticipation of afurtherfallinthepriceofthebasecurrency.Profitismadewhenthepositionisboughtbackatalowerprice.

slippagethedifferencebetweenthepriceyouexpecttoenterorexitatradeandtheactualpriceyoureceivewhenthetradeisentered.

SmithsonianAgreementanagreementreachedinDecember1971bytheG10countriestomaintainfixedexchangerateswithoutthebackingofgold.

smoothed index an index where the raw data has been adjusted for othervariablessuchastime,inflation,seasonalinfluencesorotherfactors.

spotforexalsoknownasspot,spotmarketandspotfx;acolloquialnamefortheretailforexmarket.

spreadthedifferencebetweenthebidandtheaskprice.

sterilisedinterventionoffsettingtheimpactonotherareasoftheeconomyofanation’scentralbankinterveninginthecurrencymarkets.Thebanksellsorbuys

government securities tooffset themoneyeithergenerated through the saleofthecurrency,orspentbuyingthecurrency.

stoporderanentryordertobuyabovetheprevailingmarketpriceorsellbelowtheprevailingmarketprice.Alsousedasstop-lossordersonceatradeisenteredeitherbelowtheprevailingmarketpriceinalongtrade,orabovetheprevailingmarketpriceinashorttrade.

stop lossapresetpricepointatwhicha tradewillbeexited if itmoves in theoppositedirectiontotheoneanticipated.

swap(s)seecurrencyswaps.

technicalanalysistheuseofpricecharts,indicators,patternsandalgorithmstoarriveattradingdecisions.

tickvaluetheminimumpricemoveofafuturescontract.

tradebalanceornetexports;ameasureofthedifferencebetweenexportsfromand imports into an economy trade deficit or trade gap; occurs when aneconomy imports more than it exports. A deficit is generally consideredunfavourableforboththeeconomyanditscurrency.

trade surplus when an economy exports more than it imports; a surplus isgenerallyconsideredfavourableforboththeeconomyanditscurrency.

tradeweightedindex(TWI) thevalueofacountry’scurrencyinrelationtoabasket of currencies of that country’s major trading partners. Each currencywithintheindexisgivenaweightaccordingtotheamountoftradethecountrydoeswitheachothercountry.

unwindatradetoexitatradeoropenposition.

variation margin or maintenance margin; the extra margin required by theclearing house and the brokerage firm if themark-to-market loss on an openposition(s)exceedsthebalanceinatrader’saccount.

World Bank the commonly used name for the International Bank forReconstruction and Development (IBRD) formed under the Bretton WoodsAccordattheendofWorldWarII.

yieldthereturnoninvestment.

ZEWsurveyamonthlysurveyconductedinGermanyoffinancialanalystsfromfinance,tradingandinvestmentfirms,predominantlyinGermany.