The Spot Market
The spot market accounts for nearly a third of global foreign
exchange turnover. It can be broadly divided into two tiers:
The forex market has no centralised exchanges. All trades are
over-the-counter deals, agreed and settled by individual
counterparties known to one another. The forex market is truly
global and operates 24 hours a day, Monday to Friday. Daily
trading commences in Wellington, New Zealand and follows the sun
to (inter alia) Sydney, Tokyo, Hong Kong, Singapore, Bahrain,
Frankfurt, Geneva, Zurich, Paris, London, New York, Chicago and
Los Angeles before starting again.
- The interbank market where currency is bought and sold for
delivery and settlement within two days, with the banks acting as
" wholesalers" or "market makers".
- The retail market made up of private traders, who deal over the
telephone or the internet through intermediaries (brokers).
pairs and the rate of exchange
Every foreign exchange transaction is an exchange between a pair
of currencies. Each currency is denoted by a unique
three-character International Standardisation Organisation (ISO)
code (e.g. GBP represents sterling and USD the US dollar).
Currency pairings are expressed as two ISO codes separated by a
division symbol (e.g. GBP/USD), the first representing the "base
currency" and the other the "secondary currency".
The rate of exchange is simply the price of one currency in terms
of another. For example GBP/USD = 1.5545 denotes that one unit of
sterling (the base currency) can be exchanged for 1.5545 US
dollars (the secondary currency). The base currency is the one
that you are buying or selling. This elementary point is often
lost on beginners.
Exchange rates are usually written to four decimal places, with
the exception of Japanese yen which is written to two decimal
places. The rate to two (out of four) decimal places is known as
the "big figure" while the third and fourth decimal places
together measure the "points" or "pips". For instance, in GBP/USD
= 1.5545 the "big figure" is 1.55 while the 45 (i.e. the third and
fourth decimal places) represents the points.
2.1. Bid offer spread
As with other financial commodities, there is a buying price
("offer" or "ask" price) and a selling price ("bid" price). The
difference is known as the "bid-offer spread" or "the spread".
The spread is written in a particular format, best demonstrated by
way of an example. GBP/USD = 1.5545/50 means that the bid price of
GBP is 1.5545 USD and the offer price is 1.5550 USD. The spread in
this case is 5 points.
2.2. The major pairings
All pairings with the US dollar are known as the "majors". The
"big four" majors are: -
EUR/USD denoting euro/US dollar
GBP/USD denoting sterling/US dollar (known as "cable")
USD/JPY denoting US dollar /Japanese yen
USD/CHF denoting US dollar/Swiss franc
2.3. Cross rates
Pairings of non-US dollar currencies are known as "crosses". We
can derive cross exchange rates for GPB, EUR, JPY and CHF from the
aforementioned major pairs. Exchange rates must be consistent
across all currencies, or else it will be possible to "round trip"
and make riskless profits.
The following "major" exchange rates (red) imply the "cross rates"
(blue). An illustration of how cross rates are computed is given
in Appendix A.
Every purchase of the base currency implies a reciprocal sale of
the secondary currency. Likewise, sale of the base currency
implies the simultaneous purchase of the secondary currency.
For example, when I sell 1 GBP, I am simultaneously buying 1.5545
USD. Likewise, when I buy 1 GBP, I am simultaneously selling
We can express this equivalence by inverting the GBP/USD exchange
rate and rotating the bid and offer reciprocals, to derive the USD/GBP
USD/GBP = (1/1.5550) bid; (1/1.5545) offer = 0.6431/33
This means that the bid price of one USD is 0.6431 GBP (or 64.31p)
and the offer price of one USD is 0.6433 GBP (or 64.33p). Note
that USD has now become the base currency and that the spread is 2
4.1 Units of trading - lots
As we have already seen, every forex transaction is an exchange of
one currency for another. The basic unit of trading for private
investors is known as a "lot" which consists of 100,000 units of
the base currency (although some brokers may arrange trading in
- Using the data in Table A, the purchase of a single lot of GBP/USD
will involve the purchase of 100,000 GBP at a price of 1.5852 USD
= 158,520 USD.
- Similarly, the sale of a single lot of GBP/USD entails the sale
of 100,000 GBP at 1.5847 USD = 158,470 USD.
A private investor who purchases a GBP/USD lot does not have to
put down the full value of the trade (158,520 USD). Instead, the
buyer is required to put down a deposit known as "margin" which
enables the investor to gear up the trade size to institutional
Since the sale of one currency involves the simultaneous purchase
of another, the seller of a GBP/USD lot will have bought a volume
of USD, and will also have to put down margin for the value of the
deal (158,470 USD).
The normal margin requirement is between 1% and 5% of the
underlying value of the trade. The currency denomination depends
on the brokerage through which you execute your trade. If you are
dealing through an American broker (say online), then it is likely
that you will have to deposit margin in USD even if you are
resident in the UK.
With 5,000 USD in your margin account and with margin requirement
of 2.5%, you can open positions worth 200,000 USD. Your positions
will be valued continuously. If the funds in your margin account
drop below the minimum required to support your open positions,
then you may be asked to provide additional funds. This is known
as a "margin call".
If your trade is denominated in a currency other than that
accepted by the broker, you will have to convert your gains and
losses back into an acceptable currency. For example, if you trade
a USD/JPY pair, then your gains and losses will be denominated in
JPY. If your broker’s home currency is USD, then your profits and
losses will be converted back to USD at the relevant USD/JPY offer
4.3 Going short - going long
When you buy a currency, you are said to be "long" in that
currency. Long positions are entered into at the offer price. Thus
if you are buying one GBP/USD lot quoted at 1.5847/52, then you
will buy 100,000 GBP at 1.5852 USD.
When you sell a currency, you are said to be "short" in that
currency. Short positions are entered into at the bid price, which
is 1.5847 USD in our example.
Because of the symmetry of currency transactions, you are always
simultaneously long in one currency and short in another. For
example if you exchange 100,000 GBP for USD you are short in
sterling and long in US dollars.
4.4 Closing out
An open position is one that is live and ongoing. As long as the
position is open, its value will fluctuate in accordance with the
exchange rate in the market. Any profits and losses will exist on
paper only and will be reflected in your margin account.
To close out your position, you conduct an equal and opposite
trade in the same currency pair. For example, if you have gone
long in one lot of GBP/USD (at the prevailing offer price) you can
close out that position by subsequently going short in one GBP/USD
lot (at the prevailing bid price).
Your opening and closing trades must the conducted through the
same intermediary. You cannot open a GBP/USD position with Broker
A and close it out through Broker B.
5.1 Betting on a rise
Assume that you start with a clean slate and that the current
GPB/USD rate is 1.5847/52.
- You expect the pound to appreciate against the US dollar, so you
buy a single lot of 100,000 GBP at the offer price of 1.5852 USD.
- The value of the contract is 100,000 X $1.5852 = $158, 520. The
broker wants margin of 2.5% in USD, so you must ensure that you
deposit at least 2.5% of 158,520 USD = 3,963 USD in your margin
- GBP/USD duly appreciates to 1.6000/05 and you decide to close
out your position by selling your sterling for US dollars at the
bid rate. Your gain is:
100,000 X (1.6000 – 1.5852) USD = 1,480 USD, the equivalent of 10
USD per point
- Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate
movement of less than 1%. This illustrates the positive effect of
buying on margin.
- Had GBP/USD fallen to 1.5700/75, your loss would have been:
100,000 X (1.5852 – 1.5700) USD = 1,520 USD, a return of –38.35%
The lesson is that margin trading magnifies your rate of profit or
5.2 Betting on a fall
You expect sterling to fall from GBP/USD = 1.5847/52 so you decide
to sell 1 lot of GBP/USD.
- The value of the contract is 100,000 X 1.5847 USD = 158,470 USD.
You have effectively sold 100,000 GBP and bought 158,470 USD.
- Your broker requires 2.5% of 158,470 USD as margin in US
dollars, namely 3,961.75 USD in cash
- GBP/USD falls to 1.5555/60 and you are sitting on a paper gain
100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
- Your 2,870 USD paper gain is credited to your margin account
where you now have 6,831.75 USD. This enables you to maintain open
positions worth 273,270 USD
- However, GBP/USD starts to rise. When it reaches 1.6000/05, you
are sitting on a paper loss of:
100,000 X (1.6005 – 1.5847) USD = 1,580 USD.
- Your margin account is debited by 1,580 USD, taking it down to
2,381.75 USD which is sufficient to support 2.381.75 USD/0.025 =
95,270 USD worth of open positions. Your current exposure,
100,000 X 1.6005 USD = 160,050 USD
Your "shortage in equity" is therefore 160,050 USD - 95,270 USD=
The broker makes a margin call for 2.5% of 64,780 USD = 1,619.50
USD. If you do not come up with the money tout de suite, the
broker will liquidate your position.
- You eventually close out your position at GBP/USD = 1.5720/25.
Your gain is:
100,000 X (1.5847 – 1.5725) USD = 1,220 USD.
Now that you have no more open positions, you can withdraw the
full 5,181.75 USD from your trading account in cash. Alternatively
you have enough margin to support 207,270 USD worth of positions.
Trading currencies entails risk and, as we have seen, margin
trading can greatly magnify both positive and negative returns.
Forex trading demands constant vigilance and does not fit in
easily with the human condition that requires time out for food,
rest, "comfort breaks" and leisure.
Orders that are executed immediately at current rates are known as
Market Orders. However, there are a number of automated orders
that can be triggered at pre-set price levels and that can be
deployed to control the downside and consolidate the upside: -
- Stop loss: An order to close out a position automatically
when the bid or offer price touches a given level.
If you have a long position, you may issue a stop loss order below
the current exchange rate. If the market price falls through the
stop loss trigger price, then the order will be activated and your
long position will be closed out automatically.
If you have a short position, then you would set your stop loss
above the current price to be activated when the offer price
touches the trigger level.
A "trailing stop loss" is one that is adjusted behind a position
as it moves into profit. This is a good strategy for locking in
gains. By raising the stop loss trigger price as the position
becomes increasingly profitable, the trader can ensure that most
of the paper gain is realised if the market turns downwards.
The problem with stop orders is that exchange rates may move
through the stop loss trigger prices in volatile markets, making
stops impossible to execute at the precise limits.
- Take profits order (TPO): The opposite of a stop loss
(i.e. a stop gain). The TPO order specifies that a position should
be closed out when the current exchange rate crosses a given
For a short position, the TPO order will be set below the current
exchange rate, and vice versa for a long position.
- Limit order: A buy or sell order that is activated when
the current exchange rate passes beyond some pre-set threshold
A trader may set a "buy" limit order when the exchange rate falls
below a pre-set threshold. Alternatively, a "sell" limit order may
be given for an exchange rate above a given threshold
Limit orders can be good for a specified period (e.g. a day, a
month) or "good till cancelled" (GTC). A good-for-the-day limit
order is held open for the balance of the trading day unless it is
filled before then. A GTC limit order is held open indefinitely
(unless filled) and is only terminated on instructions by the
- One cancels the other (OCO): A combination of a stop loss
and a limit order (or two limit orders) at opposite ends of the
spread. When one is triggered, the other is terminated. >
For a long position, the stop loss will be set below the market
spread and the limit sell order above the market spread. If the
base currency rate breaches the limit order threshold then the
position will automatically be sold and there is no longer the
need for the stop loss which will be cancelled. Alternatively, if
the rate falls to the stop loss trigger price, then the position
will be closed out and there will be no need for the limit order.
For a short position, the stop loss is set above the market spread
and the limit order below. If the exchange rate rises to the stop
loss trigger price then the position will be closed out and the
limit order will be cancelled. If the exchange rate falls to the
limit order trigger price, then the limit order will be activated,
the position will be bought back and the stop loss will be
The technology for trading forex has evolved from the telephone
and telex (not forgetting voice dealing) through to the modern
Electronic Broking System (EBS) that enables "straight through
processing" (STP) with integrated quotation, transactional and
EBS-type technology is now available to individual, private
investors who can receive live, streaming data from and transact
directly through their chosen brokers. The private dealer,
however, does not deal on the highly competitive inter-bank market
with its tight spreads. In practice, brokers add points to the
price spread in lieu of dealing commission.
A private trader requires:
- A margin account broker with internet access and a fast
- A computer terminal capable of running several programmes
- Proprietary software to open and manage positions and to display
technical analysis tools.
- Sufficient monitors to handle market data, submit dealing
instructions, display technical analysis; and for keeping tabs on
open positions, managing orders (e.g. stop loss, TPO, limit etc.)
and viewing the state of the margin account. For demonstrations of
the kind of proprietary software available, visit Pronet Analytics
(www.pronetanalytics.com) and Nostradamus (www.nostradamus.co.uk)
Pronet Analytics provides the only chart-based software package
approved by Association of Cambistes Internationale, the governing
body of professional forex trading.
From early 2003, a new spot trading software package from US
provider Gain Capital will be available through the UK online
margin broker Easy2Trade (www.easy2trade.com), better known for
its futures online global trading platform. "We will build our
required margin into the bid-offer spread," says Easy2Trade chief
executive David Wenman. "It will be free to use after that."
Before you splash out on the full kit, why not do a test drive by
renting a dealing desk at an organisation like TraderHouse
7.1 The screens
The trading screen is where you monitor bid and offer prices in
multiple currency pairs. A typical EBS-style screen format will
highlight the "pips" (i.e. the second and third decimal places)
where most of the movement takes place. All you have to do is pick
your moment and click on the buy and sell key.
Forex traders rely heavily on technical analysis, which uses
historical activity and price data to forecast future prices and
trends. The serious trader needs a separate monitor (and possibly
more than one) to display a range of analytical tools
We will return to the tools of technical analysis in the next
and technical analysis
Without the apparatus for making sense of the currency market, any
trade represents a pure gamble. There are two broad schools of
analysis, which are not mutually exclusive.
8.1 Fundamental analysis
Fundamental analysis is the application of micro and macroeconomic
theory to markets, with the aim of predicting future trends. So
what fundamental forces drive currency markets?
The balance of trade: Currencies that are associated with
long term trade surpluses will tend to strengthen against those
associated with persistent deficits - simply because there is net
buying of surplus currencies corresponding to the excess of
exports over imports.
Trends are important too. An improving balance of trade should
cause the relevant currency to appreciate relative to those
associated with a deteriorating or stable balance of trade.
Relative inflation rates: If country A is suffering a
higher rate of price inflation than country B, then A’s currency
ought to weaken relative to B’s in order to restore "purchasing
Interest rates: International capital flows seek the
highest inflation-adjusted returns, creating additional demand for
high real interest-rate currencies and pushing up their rates of
Expectations and speculation: Markets anticipate events.
Speculation on, say, the future rate of inflation may be enough to
move the exchange rate - long before the actual trend becomes
It should be understood that these economic forces act in concert.
It is a supremely difficult task, however, to establish where the
sum of interacting economic forces will take the market. The
solution, some argue, lies in technical analysis.
8.2 Technical analysis
Technical analysis is concerned with predicting future price
trends from historical price and volume data. The underlying axiom
of technical analysis is that all fundamentals (including
expectations) are factored into the market and are reflected in
The tools of technical analysis are now freely available to
private investors in support of their trading decisions. It cannot
be stressed too heavily, however, that such tools are only
estimators and are not infallible.
The following is the briefest of introductions to the technical
analytical tools used to identify trends and recurring patterns in
a volatile marketplace. Aspiring forex dealers are advised to
undergo proper training in technical analysis, although true
proficiency comes with practice, endurance and experience.
Line Chart: A graphical depiction of the exchange rate
history of any currency pair over time. The line is constructed by
connecting up daily closing prices.
Bar chart: A depiction of the price performance of the
currency pair, made up of vertical bars at set intra-day time
intervals (e.g. every 30 minutes). Each bar has 4 "hooks",
representing the opening, closing, high and low (OCHL) exchange
rates for that time interval.
Candlestick chart: A variant of the bar chart except that
it depicts OCHL prices as "candlesticks" with a wick at each end.
Where the opening rate is higher than the closing rate the
candlestick is "solid". Where the closing rate exceeds the opening
rate, the candlestick is "hollow".
8.2.2 Support, resistance, channels and triangles
Support and resistance thresholds are common features of all
tradeable financial commodities including currencies. Breaches of
such thresholds are taken as evidence of a fundamental change in
market sentiment towards a currency.
Support and resistance often form coherent patterns over time in
the shape of channels.
A support level is detected if you can connect up several
under-points of the exchange rate cycle on a straight line. This
is taken to indicate market reluctance to sell below certain rates
of exchange. The more under-points that can be connected, the more
evidence there is of a support level.
The support level may change with the passage of time. If the
straight line inclines upwards then we speak of "upward support".
Where the line is horizontal we identify "sideways support". Where
the line slopes downwards we diagnose "downward support".
Resistance levels indicate a reluctance to buy a currency above
given exchange rates. A resistance level is detected if it is
possible to connect a succession of upper points in the exchange
rate cycle with a single straight line.
As you would expect, one encounters upward, sideways and downward
18.104.22.168 Channels are identified by superimposing support
and resistance levels on a single line chart. Channels can slope
upward, sideways or downward.
Where resistance and support lines converge towards to one another
over time, "triangles" are formed which can be upward, sideways or
Triangles indicate declining profitability over time. Resistance
and support levels superimposed on a chart will help predict the
time of convergence. What we are seeking are "breakouts" that
could go in either direction and which are likely to be
"explosive", presenting opportunities for profitable trading.
The slope of the triangle and the behaviour of the pricing cycle
in the approach to the predicted intersection of resistance and
support may indicate the likely direction of the breakout. For
example, if the exchange rate cycle is in a clear upward phase,
the breakout is likely to be upwards also. There are some real
opportunities here, but also much risk.
22.214.171.124 Moving averages
Moving averages smooth out the peaks and troughs of the exchange
rate cycle over a rolling period and indicate the presence of a
There are two main types of moving averages:
Simple: Where past and present data are assumed to be of
equal importance and are weighted equally.
Weighted: Where current data is considered more important
than past data and is weighted more heavily. The weighting factor
takes the form of a "smoothing constant" that increases
exponentially over time.
If prices lie below two or more moving averages, this is taken as
a bearish signal, and vice versa.
126.96.36.199 Stochastic oscillators
Stochastic oscillators are momentum indicators that purport to
tell you when to buy or sell. They are composed of two elements:
When the oscillator touches 80, the currency is considered
overbought. An oscillator below 20 is considered to indicate an
- A "%K" line that measures the difference between most recent
closing price and the deepest low as a percentage of the
difference between the highest peak and the deepest low, measured
over a given period (e.g. 14 days)
- A "%D" line that tracks the 3-period (e.g. day) moving average
A rise in %K rises over %D is interpreted as a buy signal, and
|9. Tips for
aspiring spot traders
Andy Shearman, a director of forex day-trading service Trader
House Network (UK) has "Seven Pillars of Wisdom" for aspiring
forex traders: -
(1) Don’t be under-capitalised or you will lose trading
(2) Don’t suspend your daily (successful) economic activity while
you are learning to trade currencies.
(3) Get an education. Make time to practise and to check markets
(4) Decide what your monetary goals are and devise a trading plan
to realise them. Remember that you have overheads and that risk is
involved. Your target remuneration must not only be realistic but
must include a risk premium.
(5) Choose a good broker – preferably one that feeds live,
streaming prices to your screen.
(6) Be decisive. Over-caution will cost you money. You can’t make
any profits if you don’t trade. Don’t agonise too long over a deal
and trust your instincts.
(7) Watch your back. Never leave your trading screen even
momentarily without putting stop losses in place. A pee is a long
time in the forex market.
"Trading forex is a bit like life in a combat zone," says
Shearman. "There are bouts of frenetic, exhilarating and even
panic-stricken activity interspersed with periods of
uneventfulness". No one can physically trade 24 hours a day. You
need your rest and recreation."
Trader House has come up with a novel solution. It has set up a
tutorial centre (with a night school for those with a day job) and
a dealing room at the Cottesmore Country Club in West Sussex. You
can play hard in the forex markets and chill out later in the bar,
the gym, the pool or on the golf course - all for the rental of a
dealing desk. Who needs the Lottery!
Computing cross rates – an example
Assume that the following major exchange rates are known:
EUR/USD = 1.0060/65
GBP/USD = 1.5847/52
USD/JPY = 120.25/30
USD/CHF = 1.4554/59
To calculate GPB/CHF
GBP/USD: Bid: 1.5847 Offer: 1.5852
USD/CHF: 1.4554 1.4559
GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559
GBP/CHF 2.3063 2.3079