Trading on the Forex Market: Basic Concepts

Trading in Forex—the foreign currency exchange—is sometimes viewed as pure speculation. The potential for profit and, conversely, loss, are on average higher than in other commodities markets. However, as will be explained below, with Forex trading in general, and iForex in particular, there are means of mitigating potential losses, while maintaining the same opportunity for extremely high profit. The Foreign Exchange is the world’s largest financial market, with over $3 trillion traded daily. By way of comparison, the Forex market is 100 times larger than the New York Stock Exchange, and triple the size of the US Equity and Treasury markets combined. Forex is an over-the-counter market (no central trading arena), meaning that transactions are conducted via telephone or internet by a global, decentralized network of banks, multinational corporations, importers and exporters, brokers and currency traders. This is in contrast to, for example, the NYSE, which is a centralized equities trading location.

Forex is the buying of one currency and the selling of another concurrently. Typically, the major currencies—the British Pound (GSP), the Euro (EUR), the Japanese Yen (JPY), and the Swiss Franc (CHF)—are traded against the US Dollar (USD). Trade pairs in which the USD is not included are called cross pairs, and occur much less frequently.

The currency pairs are expressed with a base currency as the first part of the pair, followed by the quote currency. (For example, USD/JPY would be the US dollar as the base against the Japanese Yen as the quote.)

Accompanying the currency pair is the quota, or bid/ask price. This is expressed in the following format: EUR/USD: 1.2836 1.2839. The first number in the series represents the bid price, the cost of selling the Euro against the Dollar, or going ‘short' on the Euro. The second number is the ask price, the cost of buying the Euro against the dollar, or going ‘long’ on the Euro. The difference between the bid/ask price is called the pip spread.

A pip is the smallest unit of measure for any currency. In most currencies, this is the fifth digit, or the fourth after the decimal point; in dollars, each pip is equivalent to one-hundredth of a penny. One important exception is the Japanese Yen, in which each pip is the second unit after the decimal point, meaning each pip equals one cent.

High leverage/low margins: Most Forex providers offer traders leverages of 100 to 1. This means that for every $1000, a trader controls $100,000 worth of contracts. iForex offers traders leverages as high as 400:1, the highest level available on the market.

There is a very small amount of equity required as collateral for such a relatively large position. At iForex, there is full margin usage, meaning that a position is automatically closed only when losses equal the total available amount in the account, negating the possibility of a negative account balance. This is an important means of keeping any potential losses within a predetermined, manageable budget.

Liquidity: With $2 Trillion traded daily, Forex is the world’s most liquid market. Consequently, buy and sell orders can be filled practically instantaneously.

24-hour trading: The Forex market operates 24 hours a day, from Sunday evening to Friday afternoon EST. As a result, traders can react to any important information immediately, and are not as vulnerable to after-hour loss of value.

No bear market: There is the ability to make the same profit in any market, bullish or bearish. The strength of any particular economy is irrelevant to potential profits.

Low transaction costs: There are no hidden fees or commissions in Forex trading. Providers are paid directly from the pip spread.

Small study sample: Unlike the stock market in which there are thousands of options to choose from, there are only seven major currencies in Forex, and most successful traders limit their focus to three or four.

Today’s Forex market began to develop in 1973; however, foreign currency trading has been around since Pharaonic Egypt's advent of coinage, and the ancient Babylonian's usage of paper money. More relevant to today’s market however, are the post World War II alterations to the international exchange rate. World War II left the United States an industrial giant unscathed by the war, at least in comparison to the European powers. Worldwide confidence in the dollar made it the reserve currency of choice. To prevent a recurrence of the global depression, the Bretton Woods System, ratified by all the major capitalist countries, pegged international currencies to the dollar, which had its value, in turn, fixed in gold. This led to a system of fixed exchange rates, and the dollar's role as de facto reserve currency was formalized.

This arrangement lasted for the next three decades. In the early seventies, however, deteriorating confidence in the strength of the dollar led to market-driven currency values, and a new system of floating exchange rates took hold. The modern Forex market arose from this new arrangement.

Spot market: The most popular of the Forex trading instruments, the spot market deals exclusively with the current price of a financial instrument. A spot deal consists of a bilateral contract based on an agreed exchange rate to be delivered within two business days. The spot market is characterized by a large degree of liquidity and currency fluctuation.

Forward market: Forward trades involve future currency exchanges at a predetermined rate, based on the interest rate differential between the two relevant currencies.

Fundamental analysis examines economic, political and social indicators to predict the economic health of a nation. Currencies can be viewed as the international representative of national economies; it follows, therefore, that economic health is an important component in currency valuation. The fundamental analyst constructs forecast models based on a myriad of different indicators to predict future currency movement.

This section outlines a number of theories and indicators—as well as political dimensions and monetary considerations—that are important in constructing Forex forecast models.

Purchasing power parity: The absolute purchasing power parity (PPP) theory is based on the “law of one price”, which states that identical goods will have the same price in two countries when the exchange rate is at equilibrium. Price disparities between two identical commodities can be exploited by international arbitrageurs, who capitalize on the imbalance for profit, and in so doing push the market towards equilibrium. In practice, it is difficult to find two countries in which there are competitive markets for an identical product of identical quality, without the added cost of trade barriers, tariffs or transportation costs.

Relative PPP: Relative PPP predicts national inflation rates to determine if particular currencies are over/undervalued. For instance, if the inflation rate is higher in the US vis-à-vis Switzerland, the market will adjust the currency values to reflect the reality. This is, again, an opportunity for arbitrageurs who analyze inflationary indicators in search of profit potential.

Fundamental Indicators

While fundamental analysis helps illustrate the larger forces affecting the currency market, and long-term prospects for economic health, it has some critical failings. First, the almost limitless amount of factors that can be plugged into a forecast model might force a trader into a perpetual state of analysis, unable to pull the trigger on potential deals. More importantly, however, is fundamental analysis' uselessness in predicting entry and exit points. Technical analysis, on the other hand, ignores fundamental forces, focusing on short-term currency movements to identify trends and determine exactly when and what to buy and sell.

A trend is basically a prolonged price movement in a one direction. An upward trend can be identified by sketching a line beneath a series of lows; a downward trend by tracing a line above a series of highs. Over time, recurring price trends form support and resistance levels, or barriers at the top and bottom of the trading level. It is difficult for currencies to penetrate these levels because, over time, supply/demand has been built up in adequate abundance at both levels—demand at the floor, supply at the ceiling. These levels are obvious positions for buy/sell orders. Once these levels are definitively broken, however, they tend to form the opposite barrier.

Dow Theory

Technical analysis is based on the Dow Theory, which rests on a number of fundamental assumptions:

1. Price is a comprehensive reflection of all market forces. All the fundamental indicators described above almost immediately find expression in market pricing.

2. Price movements are trend followers. There are three types of trends: primary, secondary and daily fluctuations. Primary trend: A primary trend remains in effect until definitive signals prove otherwise. Secondary trend: A secondary trend reacts against the primary trend, and is a temporary phenomenon. In a bull market, a secondary trend is called a correction; in a bear market secondary trends are sometimes called reaction rallies. A secondary trend can retrace up to 2/3 (usually 50%) towards the starting point of the trend before resuming its primary course. Daily fluctuations: There is very little opportunity for forecasting daily fluctuations. Overemphasis on daily fluctuations can easily lead to loss.

3. Primary trends are composed of three stages: accumulation/distribution, run-up/run-down and irrational pessimism/optimism. Accumulation/distribution: During the first stage, knowledgeable traders buy/sell stocks against consensus.

Run-up/run-down: This is the longest stage of the cycle. The market begins to move, the trend is identified and trend followers jump aboard/bail out.
Irrational pessimism/optimism: Run-up/run-down is the longest stage of the cycle. At some point, investors experience irrational exuberance/despair, and the knowledgeable investor will distribute/buy holdings in anticipation of the start of a new cycle.

4. The volume of trades must confirm the trend. Movement on low volume trades can be attributed to many different ephemeral factors; high volume movements are indicative of the true direction of the market.

Elliott Wave Theory

According to the Elliott Wave Theory, a complete market cycle is composed of eight waves, including five waves in the direction of the trend and three waves against. The upward waves within a bull move are called impulse waves, and the three countertrend waves are called corrective waves.
Corrective waves follow certain rules: the second wave can never retrace more than 100% of the first wave; the third wave is never the shortest in an impulse sequence, and often the longest; and the fourth wave can never enter into the price range of the first wave.
Extensions: In any five-wave sequence, a tendency exists for one of the three impulse subwaves to extend in an elongated movement, usually with internal subdivisions, which can sometimes have nearly the same amplitude and duration as the larger waves. Extensions can provide a useful guide to the length of future waves.
Failures: Failures occur when the extreme in the fifth wave fails to exceed the extreme in the third. This signals a weakness in the underlying trend, and a sharp reversal usually follows.

Charts

Price fields: Technical traders base actions on price and volume analysis. The fields, which define a security's price and volume, are explained below.

• Open: The price of the first trade during the period.

• Close: The last price that the security traded during the period.

• High: The highest price that the security traded during the period.

• Low: The lowest price a security traded during the period.

• Volume: The number of shares (or contracts) traded during the period.

Line chart: A line chart plots single prices for a select period. The daily chart, for instance, generally illustrates the daily closing prices. The obvious problem with the daily chart is its inability to show intra-daily price activity.

Bar chart: The bar chart is the most widely used Forex chart. Each bar represents a certain time period, with the timeframe's high and low represented by the upper and lower boundary of the bar. A small line extends to the left and right of the bar, representing the opening and closing prices of the period, respectively. The closing horizontal line of one period will always be at the same level as the open of the next, forming a price continuum.

Candlestick chart: The candlestick chart is closely related to the bar chart. It also illustrates the high, low, open and close of each period. The opening and closing prices form the rectangular 'body' of the candlestick. Extending from the upper and lower sides of the body are two legs, the boundaries of each representing the high and low of the period. If the close is lower than the open, the body will be shaded; if the close is higher than the open, the body is left blank.

Chart Patterns

Currency valuation moves in trends, and these trends do not last forever. When a particular commodity experiences a countertrend, it usually is not an instantaneous phenomenon. Instead, prices decelerate, pause and reverse. These phases occur as investors form new expectations and, in doing so, shift supply/demand lines. The psychology underlining the changing of expectations often causes price patterns to emerge that are remarkably similar to one another.

Head and shoulders: The head-and-shoulders price pattern is the most reliable and well known chart pattern. It gets its name from its resemblance to a head in the middle of two shoulders. A first upward surge is followed by a secondary trend, after which a larger upward trend propels prices up past the first shoulder. After this new high, or the head, the decline begins. A second shoulder is created as bulls try to push prices higher, ultimately failing. Confirmation of a downtrend (upturn in a reverse head and shoulders) is confirmed when the neckline is penetrated.

Rounding tops and bottoms: Rounding tops/bottoms occur as expectations gradually shift between bullish and bearish.

Triangles: As the range between high and low narrows a triangle is created by drawing trend-lines above the highs and below the lows. A symmetrical triangle occurs when prices are making lower highs and higher lows. An ascending triangle occurs when there are higher lows and consistent highs, usually due to a resistance level. A descending triangle occurs when there are lower highs and consistent lows, usually due to a support level. Ascending and descending triangles often lead to breakouts, in the direction of the trend.

Double tops and bottoms: The double tops is a pattern formed when prices rise to a resistance level, falls, and then returns to the line at a lower volume level. A double top usually marks the beginning of a downtrend. The phenomenon is the same for double tops, in reverse.

Statistic Tools

Simple moving average: The simple moving average (SMA) calculates the average currency value over a select period of time (The previous 14-21 days are most common). The SMA eliminates the noise of daily fluctuations, which makes price trends and reversals easier to identify.

Moving average convergence divergence (MACD): Is the average of two cycles, a short exponential moving average and a long exponential moving average. The signal line represents the MACD over

Bollinger bands: Bollinger bands are two lines a standard deviation above and below the moving average. The Bollinger bands adjust automatically to changes in volatility, moving closer to the average during less volatile periods, further away during times of increased volatility. A tightening of the bands indicates that volatility will probably begin to increase. If the moving average moves close to the bottom Bollinger band it means the currency is being oversold, and overbought if it moves close to the top band.

Fibonacci retracement: Traders who use the Fibonacci retracement method believe that support and resistance levels can be found at key Fibonacci points. These points are located by sketching trendlines at the two extreme levels, high and low, and then dividing the vertical difference by key Fibonacci ratios—50%, 61.8% and 38.2%.

Gann fan: The Gann fan is a set of angles which define potential support and resistance point. The ideal relationship between time and price would follow the 45% line from the center of the Gann fan. In total there are eight lines extending from the base of the fan; after one line is broken, the next becomes a new support/resistance barrier.

Momentum: momentum measures the rate at which prices are falling or rising. Speculators will take a long/short position on a position exhibiting accelerated momentum, in the hope that it will continue on its path. This is a short-term method of trading, and is quite risky.

Relative Strength Index (RSI): The RSI is calculated by averaging the highs of a certain time period, averaging the lows, and then dividing the average high number by the average low number. This relative strength is put into the RSI, producing an oscillator that measures price movements on a scale between 0-100. When a price reaches the level of 30 or 70, it means it is being oversold or overbought, respectively.

Stochastic oscillator: The Stochastic oscillator illustrates the current close relative to the high-low range over a set period. The figures are plotted on a graph, with y axis values 0-100. If the Stochastic meter dips beneath 20, the commodity is considered to be oversold, overbought if it surges above 80.