Forex Basics: Getting down to business

Getting down to business 

First of all it’d be a good idea to open an account with a bank/broker. You need a new friend; you know the one, the one who will watch over your interests and desires. You have to support your friendship with material proof in the shape of a deposit (let’s begin with a few hundred Dollars). Now we are sorted and you are ready to become a true knight of the currency market. Or a queen of course, the empress of everything as far as the eye can see. Long may you reign! Now let’s clean the computer, polish up the phone: a work place should be comfortable and easy on the eye. After all, you’re going to spend a fair amount of time here. Josef K You’ll be watching over your own interests here at any time you wish over the twenty four hours in the day. When will you make your entry onto the market? It will be a solemn moment: the beginning of a glittering career. You decide. We are waiting! Theory is only truly illustrated by real examples and so we’ll respect this tradition by describing in detail how a client of ours, Josef K worked one day. The date: 28th October 2002.

 Joseph K: a working day Trading account: $800 Consequently, bearing leverage in mind, that makes $800 x 100 = $80000. Good enough to be getting on with! And they say that the people are impoverished. Would that we were all so impoverished… Note that according to the rules Josef could select a lot of any standard volume: $10000, $20000 and so on up to $80000. However, Josef is an experienced and circumspect man. He never pushes his luck and limits himself to lots of $10000. This is part of Josef’s risk management strategy. Now let’s look over Josef’s shoulder and read fragments of his diary 2pm (GMT) Josef K: So, I have considered everything, it’s time to go to work. Swiss Francs will strengthen against the dollar. I’ll put my money where my mouth is. I will sell bucks and buy francs. Come little fishes, come into my net…

Fig. 1 USD/CHF (the beginning of Josef K’s day)

A phone rings in a bank. You can read the transcript below. You did know, I take it, that we (by ‘we’ I mean banks) have every phone conversation recorded.

Josef: Hello. My name is Josef K. My password is XXXXX. Quote ten thousand US Dollars against the Swiss Franc.

Dealer: 58/63

Josef: I sell.

Dealer: You have sold ten thousand Dollars against the Swiss Franc at a rate of 1.5058.

Josef: Yes, I confirm. Josef K., password XXXXX, I’ve sold ten thousand Dollars against the Swiss Franc at a rate of 1.5058.

Well, they had a nice chat, didn’t they? It’d be nice to understand something of what they said though. As if by magic we appear and reveal all: First, each client has an individual password (for obvious reasons) which must be stated in any transaction with a dealer. Then the dealer’s words: 58/63. This is the Swiss Franc’s price. The bank buys at 1.5058 and sells at 1.5063. Accordingly the client sells at 1.5058 and buys at 1.5063. Clarity and speed are the most important factors of a trader’s (and a dealer’s) work therefore the dealer only uses the final two figures in the price of a currency. Of course, if for any reason you are unsure of the first few numbers or you do not know them (what of it? You’ve spent the last month relaxing in the Caribbean and you’ve forgotten the state of the currency market), then you can always ask for the full quote.

A few minutes after 2pm

Josef: Now the wheels are in motion, all is in the hands of the market. Now I should cover myself. I should not leave my position exposed. Think, man, think! Where should I place my orders?

What is an order? An order is a guardian angel, tiny but vigilant, who watches over wealth that has been earned through arduous labour. In other words, it is a clearly formulated command made in advance to your dealer to make a purchase or sale of a stated quantity of a specified currency as soon as its price rises or falls to values designated by you.

An order is like a thermostat on a heating system which turns itself on when the temperature drops to a certain point and turns itself off it the temperature gets too high. Orders give you the opportunity to set your profit or loss in advance and this helps you control the tendency to minimize profits and maximize losses. Just make the order and your dealer will do the necessary, protecting your interests, looking out for you. Let’s get back to Josef:

Josef: I’m counting on the Franc appreciating. I reckon the Dollar will fall. After all I’ve sold the Dollar against the Franc. What I’ll do is take profit when the rate falls to 1.4960… that is to 148 points lower than the current market (1.5058- 0.0148=1.4910). Voila! 148 points in Francs is $99.26. In case of the dollar rises, I will place a stop loss order as I was taught. Let’s place this order at 1.5100. That makes $31.12. I don’t want to lose more, that’s 47 points. I am, of course, brilliant to distraction but it pays to watch your back. The Lord helps those who help themselves, as the saying goes.

While Josef was thinking we noticed that he used a word that may be new to you, ‘point’. A point is the minimum change in the price of the exchange value of one currency against another. For example, the Swiss Franc, the Euro and the British Pound are measured in numbers with four places after the decimal point, whilst the yen has two places. Consequently for the Euro the minimum change (one point) is equal to 0.0001 of the price and for the yen it is 0.01

 

Fig 2 Chart USD/CHF with Josef’s orders

Now let us discover how Josef calculates where he should put his orders. This is the central question. Only through understanding this process is it possible to gain control. By setting at what price we take our profit ensures its stability, or at least its predictability. How do we determine the value of one point? Well, the quickest way is to check the price of a point with our trading platform IDSystem. But it’s a good idea to learn how this price is worked out. Remember that currencies are always quoted in pairs i.e. GBP/USD, USD/CHF etc. The base currency is the first currency in the pair. When the base currency is not the dollar (i.e. in the pairs GBP/USD; EUR/USD and AUD/USD) with a lot of 10000 USD a point is worth one dollar and with a lot of 100000 USD a point is worth ten dollars. When the dollar is the base currency (and this is the case for the majority of currencies) the formula to calculate the value of a point is as follows:

Cost of one point = (lot X point)/ rate of exchange of quotation against the dollar

The lot is the size of the transaction (in our example $10000) The point in terms of CHF is 0.0001 The rate of exchange of quotation against the dollar = 1.5058 So:

Cost of point = (10000 x 0.0001) / 1.5058 = $0.66

If you want to train yourself (and you should) apply this formula to your own and different currencies. So let’s calculate Josef’s potential profit. If at a rate of 1.5058 USD/CHF, he sells 10000 USD for 15058 CHF. When the USD/CHF rate falls 148 points to 1.4910, he sells the available 15058 francs and gets 10099.26 USD. He pockets the difference. The stop loss order is worked out the same way. Well that’s the math and Josef wasn’t idle: he had it all at his finger tips and he rang the bank to place his orders. Let’s listen in:

Josef: Hello, this is Josef K, my password is XXXXX. Please accept this order. Please buy ten thousand US dollars against Swiss Francs at the rate of 1.5105. This will close my position. And here is a second order. I’d like to buy ten thousand US dollars against Swiss Francs at the rate of 1.4910. This will also close my position..

Dealer: You have placed two orders. The first one: to buy ten thousand US dollars against the Swiss Franc at the rate of 1.5105. This will close your position. The second: to buy ten thousand US dollars against the Swiss Franc at the rate of 1.4910. This will close your position.

Josef: Yes I confirm. My name is Josef K, password XXXXX. I have placed two orders. The first one: buy ten thousand US dollars against the Swiss Franc at the rate of 1.5105. This will close my position. The second: buy ten thousand US dollars against the Swiss Franc at the rate of 1.4910. This will close my position.

Fig 3 USD/CHF with Josef’s orders

After making the deal, all there is to do is rest and wait for the outcome. This is exactly what Josef did as the Swiss Franc continued to gain against the Dollar. Three hours later Josef learned that his Take Profit order had been filled. Yes! Josef’s forecast was spot on and almost $100 dollars was added to his pot of 800. His account rested at 899.26 USD. Congratulations! In the twinkling of an eye … how happy a hundred dollars can make you! $100 in three hours … that’s four hundred a day… $2000 a week and in a month… We are getting carried away and we’ve forgotten the main thing, the nitty-gritty. How did Josef arrive at his forecast? Intuition? Guesswork? Some system or other? That’s a matter between Josef and his Maker. Maybe the stars whispered to him or he had a dream. I can only answer for myself. Such a forecast is based on tangibles in the shape of two great beasts which go by the names of ‘technical analysis’ and ‘fundamental analysis’. The next couple of chapters are dedicated to them.

Basics of Forex Market

The basic components of Forex

•  The currencies

 

 

The most important currencies are
• The American Dollar (USD)
• The Euro (EUR)
• The Japanese Yen (JPY)
• The Swiss Franc (CHF)
• The British Pound (GBP)
The lion’s share of the Forex market falls to these five currencies.
Listen to these figures:-
In 2001 the daily volume of conversion operations amounted to 1,798 trillion
Dollars. The London market dealt with about 32% of the turnover, the USA
markets 18% and Germany 10%. 70% of the operations involved USD. Internet
brokers processed 36% of the deals. An enormous river of money flows around our planet: An unstoppable, irresistible, ever dynamic force. Don’t you believe that it is possible to tap that force…?

•  The players

We have already made reference to the various players on the market. There are more than brokers (who you now have a passing acquaintance with) in this brave new world of ours. We need to understand who else is in the hunt.
First of all there are the large commercial banks. They often represent the interests of exporters and importers, investment institutes, insurance and pension funds, hedgers and private investors. To sum up, they serve a lot of people.
However, do not be misled into thinking that they are mere puppets, simple agents.
They were not born yesterday and they love to play on Forex a little for their own pleasure and profit. It goes without saying that giants like Deutsche Bank, Barclays Bank, Union Bank of Switzerland, Citibank, Chase Manhattan Bank and the Standard Charter Bank carry out transactions in their own interest and at their own
expense. The volumes of their daily operations reach hundreds of billions of Dollars. Very often the larger portion of their profit is made up of currency speculation.
Then there are the brokers. The voice of one broker is like a voice crying in the wilderness. For this reason they unite and form brokerage houses. They are also extremely active participants on the market; they are continually connecting buyers and sellers, handling a great number of funds and working with commission
houses, dealing centers etc.
One important fact which should always be kept in mind is that commercial banks and brokerage houses not only make deals on prices set by other active participants, they also propose their own prices, they advance their own agenda, they ensure there is always a market. In this way they influence the very formation
of prices and because of this they are known as market makers.
Finally, the central banks of various countries are also quick witted. From early in the morning to the dead of night, they go out onto the vast expanse of Forex to hunt. Pure profit is not their stated intent. Nor do they do it merely for the love of the chase, although it must pleasant to wave millions here and there…They look
after their currency and manage the existing rate. Otherwise things could get nasty and the blue skies of happiness could disappear in their country, if they ever existed at all of course.
Just because profit is not their priority does not mean to say that they carry out unprofitable operations. They are not stupid. Whenever the need arises, central banks, disguised as ‘ordinary people’ make their moves without issuing their intentions and other ‘ordinary people’ – the commercial banks – do their business too.
These then are the great movers and shakers on the market. There are also private individuals, for example me and you, who are not great at all, or, perhaps I should say, are less influential. People like us are forced to play by the rules and deal with the prices advanced by the market makers. It’s a fact and we should face up to it, but it’s not such a bleak prospect and it’s also not always plain sailing for the
market makers. I’ll talk more about this later. Of course, even among our group there is a hierarchy. Think about going to a bank and changing a hundred bucks for another currency and it will come as no surprise that you’ll exchange at the declared rate. Try the same place with say $20,000 and they will look at you
differently, I assure you, in a warmer manner. They will explain to you that the rate changes depending on the circumstances, especially for people like you.
You may be thinking: ‘Well, these big players deal in millions of Dollars. What can I do in the face of all
this?’
Ha! A lot! If you marshal your resources and potential and stop counting the money of other participants, you can succeed. Also, remember your leverage, a helping hand if ever there was one. Do you think the bank extends this credit for fun? You’ve also got the best tool of all, namely a keen mind.

•  Leverage

Let’s suppose that after a little time you save a nice round sum, say $1000. You take it down to your exchange office. A guard (such a charming fellow) closes the door behind you and takes your thousand away from you and puts it in a safe. Are you panicking? Listen to the end of my tale. While you are checking out the pictures of the new twenty dollar bill, the guard opens another safe, takes out a canvas bag, assumes an even more charming air and (surprise, surprise) gives it to you. It contains no less than $100000!!!
He tells you in a sweet confiding voice, ‘Go to the cashier’s window and buy currency X. You do so, sell the 100000 and get X. The cashier immediately sells the Dollars to the next client. You have just walked away from the window when the guard tells you to change again. You think for an hour or two, go to the
window and exchange X for Dollars. The rate hasn’t changed (I’m assuming the X is pegged) but because of the difference between the purchase price and the sale price, you make a loss. Let’s say about $100. The same procedure happens a number of times. Even an idiot will grasp that the guard (that defender of the bank’s interests) will only permit ten exchanges. You will only be allowed to make a deal while you hard earned 1000 is there to cover your losses. And then: game over. The guard will impassively take back the canvas bag (which now contains $99000) and resolutely show you the door. After adding your $1000 to the bag the bank is satisfied. $100000 remains in its vaults as before.
Oh, happy day? Yes, Oh happy day! The bank allowed you to manage an enormous sum in comparison to your outlay. But you… Calm down! It was not your fault. This was just a crude example. It illustrates how and what you lost but at least you did not fall into debt. Your risk was limited to what you had. If the rate at the exchange office had changed as dynamically as on the Forex market, then it is perfectly possible for you to have made $1000 rather than lost it. You can develop the story a bit. Your $1000 translates as $100000 after leverage. You bought and sold. You earned $100 and then another, the again $200 and another
$100. You then lost $200, then plus $100, minus $50, plus $200, plus $500 with a result of you earning $1050. When the guard takes away the bank’s money you are left with $2050 in hand.
This then is leverage. It strengthens your hand, it boosts your power and gives you the opportunity to capitalize on your price predictions. The income from the resale of $100000 will always be bigger than the income coming from $1000. However, losses will be equally magnified. So we have to work on ways of reducing losses to the minimum.

To summarize then, leverage is good on the whole. Working with leverage is more advantageous than working without: one hundred times more! We must remember the risks involved and of course leverage increases our risk factor. It’s a little like driving a Formula 1 car. If you immediately put your foot down without having any elementary driving experience, you will be killed for certain. If you approach instruction sensibly, you will be rewarded with the inexpressible feeling of the elation and freedom that you get from controlling such a powerful machine. One person may simply sit back and enjoy the contrast between this racing car and their usual family hatchback, whilst someone else will instinctively become Schumacher.