Margin balances and Liquidations

When you open an online currency trading account, you’ll need to pony up cash as collateral to support the margin requirements established by your broker. That initial margin deposit becomes your opening margin balance and is the basis on which all your subsequent trades are collateralized. Unlike futures markets or margin-based equity trading, online Forex brokerages do not issue margin calls (requests for more collateral to support open positions). Instead, they establish ratios of margin balances to open positions that must be maintained at all times.

Here’s an example to help you understand how required margin ratios work. Say you have an account with a leverage ratio of 100:1 (so $1 of margin in your account can control a $100 position size), but your broker requires a 100% margin ratio, meaning you need to maintain 100% of the required margin at all times. The ratio varies with account size, but a 100% margin requirement is typical for small accounts. That means to have a position size of $10,000; you’d need $100 in your account, because $10,000 divided by the leverage ratio of 100 is $100. If your account’s margin balance falls below the required ratio, your broker probably has the right to close out your positions without any notice to you. If your broker liquidates your position, that usually means your losses are locked in and your margin balance just got smaller.

Be sure you completely understand your broker’s margin requirements and liquidation policies. Requirements may differ depending on account size and whether you’re trading standard lot sizes (100,000 currency units) or mini lot sizes (10,000 currency units). Some brokers’ liquidation policies allow for all positions to be liquidated if you fall below margin requirements. Others close out the biggest losing positions or portions of losing positions until the required ratio is satisfied again. You can find the details in the fine print of the account opening contract that you sign.

Unrealized and Realized Profit and Loss

Most online Forex brokers provide real-time mark-to-market calculations showing your margin balance. Mark-to-market is the calculation that shows your unrealized P&L based on where you could close your open positions in the market at that instant. Depending on your broker’s trading platform, if you’re long, the calculation will typically be based on where you could sell at that moment. If you’re short, the price used will be where you can buy at that moment.

Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and you’re realized P&L. Realized P&L is what you get when you close out a trade position, or a portion of a trade position. If you close out the full position and go flat, whatever you made or lost leaves the unrealized P&L calculation and goes into your margin balance. If you only close a portion of your open positions, only that part of the trade’s P&L is realized and goes into the margin balance. Your unrealized P&L continues to fluctuate based on the remaining open positions, as does your total margin balance. If you’ve got a winning position open, your unrealized P&L is positive and your margin balance increases. If the market is moving against your positions, your unrealized P&L is negative and your margin balance is reduced.

Calculating Profit and Loss with PIPS

A pip is the smallest increment of price fluctuation in currency prices. PIPS can also be referred to as points; we use the two terms interchangeably. Looking at a few currency pairs helps you get an idea what a pip is. Most currency pairs are quoted using five digits. The placement of the decimal point depends on whether it’s a JPY currency pair, in which case there are two digits behind the decimal point. All others currency pairs have four digits behind the decimal point. In all cases, that last itty-bitty digit is the pip.

Here are some major currency pairs and crosses, with the pip underlined:

_ EUR/USD: 1.2853

_ USD/CHF: 1.2267

_ USD/JPY: 117.23

_ EUR/JPY: 150.65

Focus on the EUR/USD price first. Looking at EUR/USD, if the price moves from 1.2853 to 1.2873, it’s just gone up by 20 pips. If it goes from 1.2853 down to 1.2792, it’s just gone down by 61 pips. Pips provide an easy way to calculate the P&L. To turn that pip movement into a P&L calculation, all you need to know is the size of the position. For a 100,000 EUR/USD position, the 20-pip move equates to $200 (EUR 100,000 × 0.0020 = $200). For a 50,000 EUR/USD position, the 61-point move translates into $305 (EUR 50,000 × 0.0061 = $305).

Whether the amounts are positive or negative depends on whether you were long or short for each move. If you were short for the move higher, that’s a – in front of the $200, if you were long, it’s a +. EUR/USD is easy to calculate, especially for USD-based traders, because the P&L accrues in dollars. If you take USD/CHF, you’ve got another calculation to make before you can make sense of it. That’s because the P&L is going to be denominated in Swiss francs (CHF) because CHF is the counter currency. If USD/CHF drops from 1.2267 to 1.2233 and you’re short USD 100,000 for the move lower, you’ve just caught a 34-pip decline. That’s a profit worth CHF 340 (USD 100,000 × 0.0034 = CHF 340). Yeah but how much is that in real money? To convert it into USD, you need to divide the CHF 340 by the USD/CHF rate. Use the closing rate of the trade (1.2233), because that’s where the market was last, and you get USD 277.94. Even the venerable pip is in the process of being updated as electronic trading continues to advance. Just a couple paragraphs earlier, we tell you that the pip is the smallest increment of currency price fluctuations. Not so fast. The online market is rapidly advancing to decimalizing pips (trading in 1⁄10 pips) and half-pip prices have been the norm in certain currency pairs in the interbank market for many years.

Factoring profit and loss into margin calculations

The good news is that online FX trading platforms calculate the P&L for you automatically, both unrealized while the trade is open and realized when the trade is closed. So why did we just drag you through the math of calculating P&L using pips? Because online brokerages only start calculating your P&L for you after you enter a trade. To structure your trade and manage your risk effectively (How big a position? How much margin to risk?), you’re going to need to calculate your P&L outcomes before you enter the trade. Understanding the P&L implications of a trade strategy you’re considering is critical to maintaining your margin balance and staying in control of your trading.

This simple exercise can help prevent you from costly mistakes, like putting on a trade that’s too large, or putting stop-loss orders beyond prices where your account falls below the margin requirement. At the minimum, you need to calculate the price point at which your position will be liquidated when your margin balance falls below the required ratio.

Understanding Rollovers and Interest Rates

One market convention unique to currencies is rollovers.

A rollover is a transaction where an open position from one value date (settlement date) is rolled over into the next value date. Rollovers represent the intersection of interest-ratemarkets and Forex markets.

Currency is money, after all Rollover rates are based on the difference in interest rates of the two currencies in the pair you’re trading.

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­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­Snapshot

_ Understanding currency pairs.

_ Going long and short.

_ Calculating profit and loss.

_ Reading a price quote.

The currency market follows a particular lingo and conventions, just like any financial market. If one is new to currency trading terminologies, it may take some time getting used to it. But at the end of the day, it’s all about buying and selling.

Buying and Selling Simultaneously

Each currency trading transaction consists of a simultaneous purchase and sale. In the stock market, for instance, if you buy 500 shares of Microsoft, you own 100 shares and hope to see the price go up. When you want to exit that position, you simply sell what you bought earlier. However, in currencies, the purchase of one currency involves the simultaneous sale of another currency. For e.g. if you’re looking for the dollar to go higher, the question is “Higher against what?”

In relative terms, if the dollar goes up against another currency, that other currency also has gone down against the dollar.

Currencies Come in Pairs

Forex markets refer to trading currencies by pairs, with names that combine the two different currencies being traded, or “exchanged,” against each other. Additionally, Forex markets have given most currency pairs nicknames or abbreviations, which reference the pair and not necessarily the individual currencies involved.

Major Currency Pairs

The major currency pairs all involve the U.S. dollar on one side of the deal. The designations of the major currencies are expressed using International Standardization Organization (ISO) codes for each currency. Table 2-1 lists the most frequently traded currency pairs, what they’re called in conventional terms, and what nicknames the market has given them.

* The Euro zone is made up of all the countries in the European Union that have adopted the euro as their currency.

Major Cross-Currency Pairs

A cross-currency pair, or cross or crosses for short, is any currency pair that does not include the U.S. dollar. Cross rates are derived from the respective USD pairs but are quoted independently. Crosses enable traders to more directly target trades to specific individual currencies to take advantage of news or events

Table 2-2 highlights the most actively traded cross currency pairs.

The long and the short of it

Forex markets use the same terms to express market positioning as most other financial markets. But because currency trading involves simultaneous buying and selling, being clear on the terms helps — especially if you’re totally new to financial market trading.

Going Long

A long position, or simply a long, refers to a market position in which you’ve bought a security. In FX, it refers to having bought a currency pair. When you’re long, you’re looking for prices to move higher, so you can sell at a higher price than where you bought. When you want to close a long position, you have to sell what you bought. If you’re buying at multiple price levels, you’re adding to longs and getting longer.

Getting Short

A short position, or simply a short, refers to a market position in which you’ve sold a security that you never owned. In Forex markets, it means you’ve sold a currency pair, meaning you’ve sold the base currency and bought the counter currency. So you’re still making an exchange, just in the opposite order and according to currency-pair quoting terms. When you’ve sold a currency pair, it’s called going short or getting short and it means you’re looking for the pair’s price to move lower so you can buy it back at a profit. If you sell at various price levels, you’re adding to shorts and getting shorter. In currency trading, going short is as common as going long. “Selling high and buying low” is a standard currency trading strategy.

Currency pair rates reflect relative values between two currencies and not an absolute price of a single stock or commodity. Because currencies can fall or rise relative to each other, both in medium and long-term trends and minute-to-minute fluctuations, currency pair prices are as likely to be going down at any moment as they are up. To take advantage of such moves, Forex traders routinely use short positions to exploit falling currency prices.

Squaring up

Having no position in the market is called being square or flat. If you have an open position and you want to close it, it’s called squaring up. If you’re short, you need to buy to square up. If you’re long, you need to sell to go flat. The only time you have no market exposure or financial risk is when you’re square.

Profit and Loss

Profit and loss (P&L) is how traders measure success and failure. A clear understanding of how P&L works is especially critical to online margin trading, where your P&L directly affects the amount of margin you have to work with. Changes in your margin balance determine how much you can trade and for how long you can trade if prices move against you.

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Currencies and Other Financial Markets

There are various other markets apart from the Forex market. These are not water tight compartments and other markets like oil, gold, stocks etc are interrelated to each other. To understand markets better, one must always study the correlation between two different markets over a period of time. We must remember that all these markets work independently depending on the news, events and sentiments. They have their own independent sentiment. Do these markets interact with each other? Or is there any correlation between them? Let us have a look in detail and then reach to conclusions.

Gold

Gold is generally a hedge against inflation and a store of value in times of economic or political uncertainty. The relationship between the USD and gold is seen to be inverse, the weaker the USD the higher the gold price, and vice versa. However, these trends are shown only in long run while in the short run, each market has its own dynamics and liquidity, which makes short-term trading relationships generally tenuous. Extreme movements in gold prices tend to attract the attention of currency traders and hence influence the dollar generally in an inverse fashion.

Oil

Some countries are oil producers, so their currencies are positively (or negatively) affected by increases (or decreases) in the price of oil. If the country is an importer of oil, its currency will be hurt by higher oil prices. As per the various correlation studies, it seems that there is no significant relationship to that effect, especially in the short run, which is where most currency trading is focused. The best way to look at oil is with its relation to inflation and impact on overall economic growth. The higher the price of oil, the higher inflation is likely to be and the slower an economy is likely to grow and vice versa.

Stocks

Stocks are microeconomic securities, which rise and fall in response to individual corporate results and prospects, while currencies are essentially macroeconomic securities, which fluctuate in response to wider-ranging economic and political developments. Long-term correlation studies show that there is little or no correlation between the major USD pairs and U.S. equity markets over the last five years. The two markets occasionally intersect, though this is usually only at the extremes and for very short periods.

Bonds

The bond market is the fixed-income market and is generally more intuitively connected to the Forex market because they’re both heavily influenced by interest rate expectations. Sometimes the Forex market reacts first and fastest depending on shifts in interest rate expectations. At other times, the bond market more accurately reflects changes in interest rate expectations, with the Forex market later playing catch-up. Overall, as currency traders, one definitely needs to keep an eye on the yields of the benchmark government bonds of the major-currency countries to better monitor the expectations of the interest rate market.

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Around the World in a Trading Day

The Forex market operates 24×7 when it opens on Monday morning in the Asia-Pacific time zone up to Friday at the close of business hours in New York. At any given point in time, depending on the time zone, some or the other global financial centres — such as Sydney, Hongkong, or London — are active, and the currency trading desks in those financial centres are open in that market. Currency trading is active on holidays also, unlike other financial markets, like stock exchange or futures and options market. For e.g. although it’s a holiday in Tokyo, Sydney, London, and Hong Kong may still be active. There is one common holiday across the world that is the New Year’s Day, but even that may occur at different points of time in different countries.

The opening of the trading week

There is no official starting time to the trading day or week as such, but for all intents the market kicks off when the first financial centre west, Wellington, New Zealand, of the international dateline, opens on Monday morning local time. It roughly corresponds to early Sunday afternoon in North America, Sunday evening in Europe and very early Monday morning in Asia.

In North America the trading session opens on a Sunday afternoon where currency markets resume after the Friday close of trading (5 p.m. Eastern time). This is the point where Forex market reacts to news and events that could have happened over the weekend. The prices at which the market may have closed in New York may not remain same over weekend and when it opens again on Sunday, the trading may start at a completely different level.

Trading in the Asia-Pacific Session

As per the 2004 survey, the currency trading volumes in the Asia-Pacific session are approximately 21 percent of total global volume per day. The principal trading centres are Wellington, New Zealand; Sydney, Australia; Tokyo, Japan; Hong Kong; and Singapore. If we look at the most traded currency pairs, the predictions say that it is going to be from New Zealand, Australia, and Japan. On account of the huge size of the Japanese market and the importance of Japanese data to the market, a lot of the action at the Asia-Pacific session is focused on the Japanese yen currency pairs, such as USD/JPY i.e. the U.S. dollar/Japanese yen and similarly the EUR/JPY and AUD/JPY. Since the Japanese financial institutions are also most active during this session, so we can actually get a sense of what the Japanese market is doing based on price movements. For individual traders, the information about overall liquidity in the major currency pairs is more than enough. There are some non liquid currencies like GBP/USD or USD/CAD where price movements may be more erratic or nonexistent, depending on the environment.

Trading in the European/London session

European financial centres begin to open up when the Asian market is at its midway. As per the 2004 survey, European financial centres and London handle approximately 50 percent of total global trading volume in a day, while London alone accounts for about one-third of the average total global volume per day. The time when European market opens the market interest and liquidity is at its absolute peak. News and data from Europe zone (and individual countries like Germany and France), Switzerland, and the United Kingdom is typically released in the early-morning hours of the European session. Hence, a lot of active trading happens in the European currencies (EUR, GBP, and CHF) and among the euro cross-currency pairs. In the late morning session of Europe, the Asian trading centres begin to wind down, while North American trading session comes in a few hours later, around 7 a.m. ET.

Trading in the North American Session

As we now know that there is a significant overlap time in trading sessions of Europe and North America, hence the trading volumes during this session are much more as compared to other times. Some of the most significant transactions take place during this cross-over time. The North American trading session alone accounts for roughly about 22 percent of global trading volume per day. The key economic data is released in the North American morning and this is the time when the Forex market makes decisions on the value of the U.S. dollar. Let us have a look at the timings when the North American data is released: Most of the U.S. data reports are released at 8:30 a.m. ET, Canadian data reports are also released between 7 and 9 a.m. ET, a few of the U.S. economic reports that variously come out at noon or 2 p.m. ET, livening up the New York afternoon market. By this time, London and the European trading sessions begin to wind up their daily trading operations around noon eastern time (ET) each day. On most days, during North American afternoon the market liquidity and interest fall off significantly, this can make for challenging trading conditions.

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Chapter 1-Forex Market Basics

You will learn:

_ What is a Forex market?

_ Understanding that speculation is the key!

_ Currencies traded across the world!

_ How financial markets and currencies climb!

The Foreign Exchange Market trades currencies. The Foreign Exchange Market (Forex) is the most traded financial market in the world. The purpose of the Forex market is to facilitate international trade and investment. Various businesses want to convert one convert one currency to another, and Forex market helps in that. For example, it permits an Indian business to import American goods and pay Dollars, even though the business’s income is in Indian Rupees.

Whether it’s an Asian pension fund investing in American Treasury bonds, or a British conglomerate purchasing a Chinese manufacturing facility, each cross-border transaction passes through the Forex market at some stage. Moreover, it’s a market that never sleeps; it is open 27×7, enabling traders to act immediately to news and events. It’s a market where trade worth half-billion-dollar can happen in a matter of seconds and the same may not reflect on prices, while the same is not the case with any other market.

Getting into Calculations

Can you imagine the volume of transactions in the Forex market per day? It is more than $2 trillion. That’s a mind-blowing number, isn’t it?

To have a comparative overview, it is about 10 to 15 times the combined trading volume of all the world’s stock markets.

Speculation is the key

The amount based on speculation is much more than the volumes of commercial and financial transactions in the currency market. Speculation is about traders buying and selling on a short-term basis depending on minute-to-minute, hour-to-hour, and day-to-day price fluctuations. Estimates say that more of 90 percent of daily trading volume comes from speculation (meaning, commercial or investment-based transactions account for less than 10 percent of the average daily volume). This shows that the liquidity of the overall Forex market is incomparable to any other global financial market in the world. The majority of spot currency trading, approximately 75 percent, happens to take place in the “major currencies,” i.e. the currencies of world’s largest and most developed countries. Moreover, activity in the currency market majorly functions on a regional “currency bloc” basis, where the bulk of trading takes place between the USD bloc, JPY bloc, and EUR bloc.

Getting liquid without getting soaked

Liquidity refers to the level of buying and selling volume available at any given point of time for a particular asset or security. The higher the liquidity, the easier and faster it is to buy or sell a security. From a trading point of view, liquidity is an important consideration because it tells us how fast the prices can move between trades. Since Forex is a highly liquid market, it can see transactions worth millions of dollars without any significant price changes. On the other hand, an illiquid market tends to see price fluctuations more quickly even on relatively lower trading volumes.


“Part 2 of Forex Market Basics will follow”!