The Forex market came into existence in the 1970’s when the United States abandoned the gold standard as benchmark for the value of the US Dollar. Forex in itself is an abbreviation for foreign exchange and the root purpose of the market is to evaluate the currency of one country to the currency of another country.
It was in 1973 that the countries which formed part of the industrialized world decided to make their currencies freely available to trade. This immediately formed the exchange rate in terms of value of one currency pitted against another. This further led to the establishment of currency prices being quoted on a daily basis. The explosion in computer technology made foreign exchange transactions possible in most parts of the world. Due to the foreign exchange markets, the world today is truly a global village and it is possible to perform intercontinental business transactions from every corner of the world.
For a better understanding of the foreign exchange market, attributes of the market will be highlighted. This is an effort to shed light about the currency market to facilitate the move to become a Forex trader:
- Currencies are always traded in pairs in the Forex market. For every foreign exchange transaction, one currency is traded for another, i.e. GBP/USD will translate to how many Dollars it will take to purchase a British Pound.
- Symbols are being used to indicate currencies. The GBP symbol indicates the Pound Sterling and the USD symbol indicates the United States Dollar. Other symbols include the AUD for the AUSTRALIAN Dollar, the EUR for the European Union euro, CHF for the Swiss Frank and the JPY for the Japanese YEN to name but a few.
- There are current approximately 150 currency pairs available which could be traded in the currency market
- There is a market price associated with each currency pair, i.e. EUR/USD, GBP/USD, USDJPY. This price refers to how much of the second currency it will cost to buy one unit of the first currency. An exchange rate for the GBP/USD is 1.2801, then it costs 1.2801 US Dollars to purchase a Pound Sterling.
On the reverse side, to establish how much it will cost in Pounds to buy a US Dollar, the calculation is flipped, and 1 (one) is divided by 1.2801 to give answer of 0.7811. It therefore costs 0.7811 US Dollars to buy one Pound. The price of the currencies constantly fluctuates as global transactions occur, 24 hours a day during the week.
- A pip is the fourth decimal in place in a currency pair. When the Japanese Yen is involved as the second currency, the pip is the second decimal. When the price of the GBP/USD moves from 1.2800 to 1.250, a profit of 50 pips have been made – if you were in a buy transaction. If you were in a sell transaction and the price moved from 1.2800 to 1.2750, you would have a 50 pip
- The profit made depends on how much of the currency were bought or sold. Currency pairs are transacted in lot sizes. The standard lot size is 100 000 units, the mini lot size is 10 000 units and the micro lot size is 1 000 units. A standard lot size pip is worth $10,00, the mini lot size is worth $1,00 and the micro lot size pip is worth $0.10. This is on the assumption that the accounting of the trade account is in US Dollars.
- For any pair where the USD is the second currency, the pip values in the previous paragraph applies. However, if the USD is quoted first, the pip value will be different. Example: The pip value of the USD/CHF (Swiss Franc), the normal pip value is divided by the current USD/CHF exchange rate. Thus, a micro lot size is worth $0,10 / 0.9435 = $0.1060, where 0.9435 is the current price of the pair, and subject to change.
- The JPY pairs (USD/JPY), follows the same process, but is then multiplied by 100.
- In terms of trading, the first currency in a trading pair is always the directional currency on a forex chart. In the GBP / USD chart, when the price is moving higher, it means the Pound Sterling is moving higher relative to the USD. Similarly, if the price on the chart is falling and moving lower, then the Pound is declining in value relative to the US Dollar.
- There are three forms of commissions used by brokers in forex. These commissions are the cost of forex transactions. The commission structures are not universal to all brokers and each broker applies the structure as they would see fit. The cost structures are (a) a fixed spread, (b)a variable spread; and (c)a commission based on a percentage of a spread.
The spread is the difference between the bid price (what the broker is prepared to pay for your currency) and the ask price (the price the broker is prepared to sell the currency)(The ask price is always higher than the bid price)
In a quote “EURUSD: 1.4952 – 1.4955” there is a difference of 3 pips (as calculated on the fourth decimal). This difference is called the spread. With a broker offering a fixed spread, the trader will always pay 3 pips transactions costs. In the case of a broker with a variable spread, the spread would move up and down, depending on the currency pair being traded and the market volatility level.
Some brokers charge a small commission, sometimes as little as two-tenths of one pip and the trade will be passed on to a larger market maker with whom a relationship exists. This larger market maker could be able to provide a very tight or small spread that only larger traders could access.
- Forex interest or rollover is another cost to take into consideration. Rollovers are the interest paid or earned for holding a currency transaction open overnight without settling. Each currency has an overnight interbank interest rate associated with it, and because forex is traded in pairs, every trade not only involves two different currencies, but also two different interest rates. The rates involved here are not central bank rates, but the overnight interest rates at which banks borrow unsecured funds from other banks. Should the interest rate on the currency the trader bought be higher than the interest rate of the currency sold, interest would be earned on the transaction. If the interest rate on the currency bought is lower than the interest rate on the currency sold, the trader will pay rollover interest.
- Rollover rates on a Wednesday is three times higher than on a Tuesday. This is to account for the fact that banks are globally closed over the weekends and therefore the interest for the weekends are made up on a Wednesday.
With these concepts the new traders should have a better understanding of what is happening when there are movement on a forex chart. It will be easier to identify the profit potential available from chart movements.