What's Forex, Reading Quotes & USD Index

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Introduction

We can all trade currencies thanks to The Internet.  With a few clicks we can open a Forex leveraged account, transfer some money then start trading.  However, we must understand currency before we start trading, so this and subsequent lessons will help you through the foreign exchange minefield.

What is Forex?

Forex is The Foreign Exchange Market.  It's where currency pairs are traded in an over the counter (OTC) fashion - unlike stocks, which have central marketplaces.  Commercially, Forex is Invested, Traded and Hedged and we can do the same as a retail customer.  The Forex market is the largest, most liquid market in the world.  Why?  Well, we need to exchange currencies to undertake international trade and because it's so international it's open 24 hours a day, 5 1/2 days a week.

When people talk about The Forex Markets, they're invariably talking about 'The Spot' Market.  There are two other markets - the 'futures' and the 'forwards' markets.  These are primarily used by Commercial Hedgers, needing to hedge currency risk against future fluctuations, as well as large corporate speculators who trade for profit.  In the spot market currencies follow demand and supply dynamics and are bought and sold at current prices.  The following factors influence currency prices:
  • Interest rates
  • Economic activity
  • Market Sentiment
  • Political factors
  • Bond spreads
We'll talk more about these factors in the next lesson - What Affects Currency Fluctuations.  The currency 'spot deal' is a bilateral transaction between a buyer and a seller. After a position is closed, the settlement is in cash.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange.

Reading Forex Quotes

Currencies prices are usually quoted in relation to other currencies - called currency pairs.  The currency on the left is the base currency and the currency on the right is called the counter currency or quote curency.  The base currency is always 1.  

I.e. a quote of USD/JPY = 121.50 means $1=121.50 Yen.

The USD is usually the base currency in the spot Forex Market, but there are exceptions (the futures markets can be different).  The queens currencies - GBP (British Pound), AUD (Aussie Dollar) and NZD (NZ Dollar) are all quoted as the base against USD as is The Euro (EUR). Just to complicate things the EUR is the base currency against GBP.  

I.e. The Euro is quoted as EUR/USD 1.31, meaning 1 Euro = US$ 1.31.

Those currency pairs that have the USD as a component are the most liquid (The most traded).  We've talked about Liquidity before - the more liquid a market is then the less volatile it's likely to be, allowing us to trade with reduced fear of market shocks.  When a market doesn't have USD as one of it's components it's called a cross-currency market.  Check the interest in these markets before trading by using The COT report as a volume indicator.  

Pips

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places. The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places.

So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day, so if a market moves by 80 pips it has really only moved by 0.0080 in real money.  This small movement and leverage allow traders to make, or lose money.

Spreads, Bids and Asks

When faced with a currency pair or cross currency quote you'll notice there is a bid and ask price for each market.  When buying, or going long we use the ask price.  The ask price is the amount the market will sell you of the quoted currency for 1 of your base currency.  When selling, or going short we use the bid price.  The bid price is how much the market is willing to pay in the quoted currency.

A typical price will look like this:

USD/CAD = 1.2000/05
Bid = 1.2000
Ask = 1.2005

So if we were ready to trade and go long USD we would buy 1 USD with 1.2005 CAD.  If we were to go short USD we'd sell 1 USD for 1.2000 CAD. So, if we were to buy and sell immediately we would loose 5 pips - buy at 1.2005 and sell at 1.2000.

Please bear in mind that the base currency is always the currency the transaction is being completed in.  So if your Forex account is in GBP, EUR, NZD etc... there will be a currency exchange transaction fee if the base currency is not the same as your account currency.  See Position Sizing for more on this.

The difference between the bid and ask is called the spread.  So in the above case the spread is 0.0005 or 5 pips or points.  This spread can increase or decrease depending on the currency pair and the liquidity of the market. In general the more liquidity there is in the market, the closer the spread and the spread will widen in times of market turmoil. The spread represents a part of the brokers profit.

The Futures and Forwards markets quote a little differently.  The USD is always the quote (counter) currency, i.e   it comes second.  This is fine if the USD is also the same in the spot market, like GBP/USD or EUR/USD.  However, USD/JPY or USD/CAD etc... would be reversed in the futures and forwards markets. Make sure you know which market your trading in before entering. It can be confusing...

The Dollar Index (USDX)

The USDX is NOT a currency pair, it's an index.  It's a weighted average of a basket of currencies measured against The USD.  These currencies are:
  • EUR (Euro - 57%)
  • JPY (Yen - 14%)
  • GBP (Pound - 12%)
  • CAD (Canadian - 9%)
  • CHF (Swiss - 4%)
  • SEK (Swedish Krona - 4%). 
It goes up and it goes down, just like stock markets.  As it's heavily weighted to EUR there is a strong correlation between the USDX and EUR/USD currency pair - USDX goes up, then EUR/USD goes down.

NB. You may hear the words "Trade-Weighted US Dollar Index".  This is not the same. The trade-weighted index includes countries from all over the world, including some developing countries. Top weights (as of 2010) are Europe 18%, China 17%, Canada 15%, Mexico 10%, etc...

The USDX can be used as an indicator of USD strength against other currencies, particularly EUR/USD (because of it's weighting). Breakouts in spot USDX will almost certainly move the EUR/USD in similar breakout fashion. 

NB. if USDX increases then pairings with USD to the front increase (eg.USD/CHF) and pairings with USD second decline in price (eg. EUR/USD).  The front currency is called the 'Base Currency' and the second currency is called The 'Quote Currency'

More...


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Introduction

We can all trade currencies thanks to The Internet.  With a few clicks we can open a Forex leveraged account, transfer some money then start trading.  However, we must understand currency before we start trading, so this and subsequent lessons will help you through the foreign exchange minefield.

What is Forex?

Forex is The Foreign Exchange Market.  It's where currency pairs are traded in an over the counter (OTC) fashion - unlike stocks, which have central marketplaces.  Commercially, Forex is Invested, Traded and Hedged and we can do the same as a retail customer.  The Forex market is the largest, most liquid market in the world.  Why?  Well, we need to exchange currencies to undertake international trade and because it's so international it's open 24 hours a day, 5 1/2 days a week.

When people talk about The Forex Markets, they're invariably talking about 'The Spot' Market.  There are two other markets - the 'futures' and the 'forwards' markets.  These are primarily used by Commercial Hedgers, needing to hedge currency risk against future fluctuations, as well as large corporate speculators who trade for profit.  In the spot market currencies follow demand and supply dynamics and are bought and sold at current prices.  The following factors influence currency prices:
  • Interest rates
  • Economic activity
  • Market Sentiment
  • Political factors
  • Bond spreads
We'll talk more about these factors in the next lesson - What Affects Currency Fluctuations.  The currency 'spot deal' is a bilateral transaction between a buyer and a seller. After a position is closed, the settlement is in cash.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange.

Reading Forex Quotes

Currencies prices are usually quoted in relation to other currencies - called currency pairs.  The currency on the left is the base currency and the currency on the right is called the counter currency or quote curency.  The base currency is always 1.  

I.e. a quote of USD/JPY = 121.50 means $1=121.50 Yen.

The USD is usually the base currency in the spot Forex Market, but there are exceptions (the futures markets can be different).  The queens currencies - GBP (British Pound), AUD (Aussie Dollar) and NZD (NZ Dollar) are all quoted as the base against USD as is The Euro (EUR). Just to complicate things the EUR is the base currency against GBP.  

I.e. The Euro is quoted as EUR/USD 1.31, meaning 1 Euro = US$ 1.31.

Those currency pairs that have the USD as a component are the most liquid (The most traded).  We've talked about Liquidity before - the more liquid a market is then the less volatile it's likely to be, allowing us to trade with reduced fear of market shocks.  When a market doesn't have USD as one of it's components it's called a cross-currency market.  Check the interest in these markets before trading by using The COT report as a volume indicator.  

Pips

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places. The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places.

So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day, so if a market moves by 80 pips it has really only moved by 0.0080 in real money.  This small movement and leverage allow traders to make, or lose money.

Spreads, Bids and Asks

When faced with a currency pair or cross currency quote you'll notice there is a bid and ask price for each market.  When buying, or going long we use the ask price.  The ask price is the amount the market will sell you of the quoted currency for 1 of your base currency.  When selling, or going short we use the bid price.  The bid price is how much the market is willing to pay in the quoted currency.

A typical price will look like this:

USD/CAD = 1.2000/05
Bid = 1.2000
Ask = 1.2005

So if we were ready to trade and go long USD we would buy 1 USD with 1.2005 CAD.  If we were to go short USD we'd sell 1 USD for 1.2000 CAD. So, if we were to buy and sell immediately we would loose 5 pips - buy at 1.2005 and sell at 1.2000.

Please bear in mind that the base currency is always the currency the transaction is being completed in.  So if your Forex account is in GBP, EUR, NZD etc... there will be a currency exchange transaction fee if the base currency is not the same as your account currency.  See Position Sizing for more on this.

The difference between the bid and ask is called the spread.  So in the above case the spread is 0.0005 or 5 pips or points.  This spread can increase or decrease depending on the currency pair and the liquidity of the market. In general the more liquidity there is in the market, the closer the spread and the spread will widen in times of market turmoil. The spread represents a part of the brokers profit.

The Futures and Forwards markets quote a little differently.  The USD is always the quote (counter) currency, i.e   it comes second.  This is fine if the USD is also the same in the spot market, like GBP/USD or EUR/USD.  However, USD/JPY or USD/CAD etc... would be reversed in the futures and forwards markets. Make sure you know which market your trading in before entering. It can be confusing...

The Dollar Index (USDX)

The USDX is NOT a currency pair, it's an index.  It's a weighted average of a basket of currencies measured against The USD.  These currencies are:
  • EUR (Euro - 57%)
  • JPY (Yen - 14%)
  • GBP (Pound - 12%)
  • CAD (Canadian - 9%)
  • CHF (Swiss - 4%)
  • SEK (Swedish Krona - 4%). 
It goes up and it goes down, just like stock markets.  As it's heavily weighted to EUR there is a strong correlation between the USDX and EUR/USD currency pair - USDX goes up, then EUR/USD goes down.

NB. You may hear the words "Trade-Weighted US Dollar Index".  This is not the same. The trade-weighted index includes countries from all over the world, including some developing countries. Top weights (as of 2010) are Europe 18%, China 17%, Canada 15%, Mexico 10%, etc...

The USDX can be used as an indicator of USD strength against other currencies, particularly EUR/USD (because of it's weighting). Breakouts in spot USDX will almost certainly move the EUR/USD in similar breakout fashion. 

NB. if USDX increases then pairings with USD to the front increase (eg.USD/CHF) and pairings with USD second decline in price (eg. EUR/USD).  The front currency is called the 'Base Currency' and the second currency is called The 'Quote Currency'

More...


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