Trading in The Forex Spot Market

Role of the Forex Market Maker

Often referred to as a dealer or a broker, a forex market maker provides a two-way quote for each currency pair it offers.

A two-way quote consists of a bid price and an ask price, and represents the exchange rate at which the market maker is willing to buy or sell the currency pair.

The exchange rate as published by a forex broker, advertises the current rate at which you can trade (exchange) one currency for another.

If currency A is worth 1.25 of currency B for example, and you wanted to exchange 500 units of currency A, you would receive 625 units of currency B (500 1.25).

Looking at this the other way, if you instead needed 1200 units of currency B, but only had currency A, you would need to exchange 960 units of currency A to get the required amount of currency B (1200 1.25).

Exchange Rate Describes how much of one currency can be bought or sold in exchange for one unit of another currency.

Spot Trade Settlement

Spot trades in the forex market are intended for immediate settlement. This means the trade is considered to have been completed (or executed) once the buyer and the seller agree to the terms of the trade.

The physical delivery of the currencies involved in the trade however, can take up to two days after the trade itself. This is the settlement date.

In the industry, this is referred to as "T+2" which stands for "trade day plus two days" for the settlement (the physical delivery of the currencies) to be completed.

T+2 is a throwback to the days when trading was conducted mostly using fax machines or over the telephone. While these methods allowed for instantaneous agreement between the trade participants, it could take several days for the actual transfer of funds between the buyer and seller accounts.

Spot Trade A contract to buy or sell a specified amount of a currency pair at a given exchange rate.

Buying and Selling Currency Pairs

The exchange rate describes how much one currency can buy of another currency.

For example, the most commonly-traded currency pair consists of the euro and the U.S. dollar. It is always listed as EUR/USD and never the reverse order.

When buying EUR/USD, you are actually buying euros while simultaneously selling U.S. dollars; when selling EUR/USD, you are selling euros and buying U.S. dollars.

Anatomy of a Currency Pair

The first currency listed in the currency pair is called the base currency; the second currency is referred to as the quote, or sometimes counter currency.

When published with an exchange rate, the currency pair indicates how much of the quote currency is required to purchase one unit of the base currency. For example, EUR / USD = 1.5467 indicates that one euro can buy 1.5467 US dollars.

When selling a currency pair, the exchange rate shows how many units of the quote currency you will receive when selling one unit of the base currency.

By enforcing these strict standards on how to refer to currency pairs, mistakes are reduced and it is easier to keep exchange rates organized and clearly understood.

Exchange Rates and Spreads

Each currency pair listed by your broker is accompanied by an exchange rate that shows the bid and ask price for the currency pair.

The bid price is the rate that your broker is willing to pay for the currency pair; in other words, this is the rate you receive if selling to the market.

The ask price is the rate at which your broker is willing to sell and represents the rate you must pay to buy the currency pair.

The bid price is always less than the ask price because brokers pay less than they receive for the same currency pair. This difference known as the spread is how your broker generates much of its revenue.

The illustration at the top of this page shows how brokers typically display a currency pair to show the current bid and ask price.

In this example, the bid is 1.4745 dollars to each euro, while the ask is 1.4746 dollars to each euro.

The bid price is always shown before the ask, and because the difference between two prices tends to be very small, brokers usually only display the last two digits when showing the ask price.

The spread represents your cost to trade with the broker. Spreads can vary significantly from broker to broker so it is very much in your interest to trade with the broker offering the best (i.e. the tightest) spreads in order to minimize your trading costs.

What are Pips in Forex

Overview

Pip = "price interest point". A pip measures the amount of change in the exchange rate for a currency pair. For currency pairs displayed to four decimal places, one pip is equal to 0.0001. Yenbased currency pairs are an exception and are displayed to only two decimal places (0.01).

Some brokers now offer fractional pips to provide an extra digit of precision when quoting exchange rates for certain currency pairs.

A fractional pip is equivalent to 1/10 of a pip.

OANDA introduced fractional pips - or "pipettes" - to allow for tighter spreads on certain currency pairs. For instance, it is possible to view the EUR/USD currency pair with pipettes (i.e. five decimal places), while currency pairs with the yen as the quote currency can be viewed to three decimal places instead of the default two decimal places. Forex traders often use pips to reference gains or losses. For a trader to say "I made 40 pips on the trade" for instance, means that the trader profited by 40 pips. The actual cash amount this represents however, depends on the pip value.

Determining Pip Value

The monetary value of each pip depends on three factors: the currency pair being traded, the size of the trade, and the exchange rate.

Based on these factors, the fluctuation of even a single pip can have a significant impact on the value of the open position.

For example, assume that a $300,000 trade involving the USD/CAD pair is closed at 1.0568 after gaining 20 pips. To calculate the profit in U.S. dollars, complete the following steps: 1. Determine the number of CAD each pip represents by multiplying the amount of the trade by 1 pip as follows: 300,000 x 0.0001 = 30 CAD per pip

2. Divide the number of CAD per pip by the closing exchange rate to arrive at the number of USD per pip: 30 1.0568 = 28.39 USD per pip

3. Multiply the number of pips gained, by the value of each pip in USD to arrive at the total loss / profit for the trade: 20 x 28.39 = $567.80 USD profit

Additional Examples*

Currency Pair EUR/GBP

o o o

Exchange Rate at Close 0.8714

Pip Change +29

Trade Amount 350,000 EUR

Number of GBP per pip: 350,000 0.0001 = 35 Per Pip Value: 35 0.8714 = 40.17 EUR per pip Trade Profit / (Loss): 29 pips 40.17 = 1, 164.93 Euros Exchange Rate at Close 1.2703 Pip Change -17 Trade Amount 175,000 AUD

Currency Pair AUD/NZD

o o o

Number of NZD per pip: 175,000 0.0001 = 17.5 Per Pip Value: 17.5 1.2703 = 13.78 AUD per pip Trade Profit / (Loss): (17) pips 13.78 = (-234.26) Australian Dollars Exchange Rate at Close 83.84 Pip Change +18 Trade Amount 500,000 CHF

Currency Pair CHF/JPY

o o o

Number of JPY per pip: 500,000 0.01 = 5,000 Per Pip Value: 5,000 83.84 = 59.64 CHF per pip Trade Profit / (Loss): 18 pips 59.64 = 1,073.52 Swiss Francs Exchange Rate at Close 91.16 Pip Change -27 Trade Amount 200,000 USD

Currency Pair USD/JPY

o o o

Number of JPY per pip: 200,000 0.01 = 2,000 Per Pip Value: 2,000 91.16 = 21.94 USD per pip Trade Profit / (Loss): (27) pips 21.94 = (-592.38) U.S. Dollars

* For the sake of simplicity, assume all examples are buy transactions.
Naturally, all brokers claim they offer the best spreads, but simply saying something, does not make it so. It is up to you to do your investigative homework to identify brokers that offer the best value.

How Uncertainty in the Market Affects Spreads

Impending news, such as inflation reports and central bank meetings, are the most common events that cause spreads to widen.

Once the news of an event is absorbed by the market and it becomes clearer which way the currency will go, the spread generally snaps back to typical levels.

We'll talk more about spreads and what causes spreads to vary in Lesson 5 A Primer to Fundamental Analysis.

Unlike other forex brokers, OANDA allows weekend trading. However, due to the reduced liquidity, spreads will likely be wider than those posted during regular market hours.

How to Close an Open Position in Forex

Overview

Active trades are referred to as open positions. Open positions remain subject to fluctuations in the exchange rate. Open positions are closed by entering into a trade that takes the opposite position to the original trade.

The net effect is to bring the total amount for the currency pair back to zero.

Realizing Gains / Losses

It is important to understand that gains or losses for open positions are still unrealized. Only when you close a position do you actually realize the gains or losses for the trade, thereby affecting the actual cash balance of your account.

Closing a Long Position

To close a long position, you must sell an equal amount of the same currency pair to reduce your long position to zero.

For instance, if you are long $100,000 EUR/USD, you need to sell $100,000 EUR/USD back into the market to reduce your EUR/USD holdings to zero.

If you receive more when you sell than you paid to buy the order, you earn a profit. If you receive less, you realize a loss.

Closing a Short Position

A short position is the opposite of a long position think of it as holding a negative amount of a currency pair.

In order to close a short position, you need to buy enough of the currency pair to bring your position back to zero.

For instance, if you are short $100,000 EUR/USD, then you must buy $100,000 EUR/USD to close the short position. If you can buy this back for less than you earned when you sold it originally, the difference is retained as profit.

Partial Position Close

It is possible to partially close an open position by only selling or buying enough to partly offset the open position.

For example, selling only $75,000 when you have an open position of $100,000 EUR/USD, closes three-quarters of the original position, leaving an open EUR/USD position of $25,000.

What are End-of-Day Rollovers in Forex

Overview

An end-of-day rollover also known as a rollover swap is used by brokers to process open positions so they can be held over to the following day.

Rollovers implement a cut-off point for the day's business, after which any new business is dated the following day and becomes part of the next day's business.

Rollovers are necessary to determine a daily valuation for open transactions in order to calculate interest for the positions.

When trading in a margin account, you receive interest on your long positions, while paying interest on short positions.

The net interest difference is known as the carry. Positive carry results when you receive more in interest than you are required to pay, and is added directly to your account. If the carry is negative, it is subtracted from your account.

Most brokers perform the rollover automatically by closing open positions at the end of the day, while simultaneously opening an identical position for the following business day. This is also known as a "tomorrow next" transaction, or simply a "tom next".

Intra-day trades are not included in the interest calculation for those brokers who use rollovers in this manner. If you open and close a trade within the same day and do not hold it open at the time your broker performs the end of day valuation, the trade has no interest implications.

Forex Training Summary and Quiz

Currency Trading Conventions

Currencies are traded in currency pairs - for example EUR/USD. In this case, EUR is the base currency and USD is the quote or counter currency.

When you buy the EUR/USD currency pair, you are simultaneously buying euros and selling an equivalent amount in US dollars. When selling EUR/USD, you are selling euros and buying USD.

Exchange rates for currency pairs are displayed with both a bid price (what you receive when selling) and an ask price (what you pay when buying).

The difference between the bid price and the ask price is known as the spread. "Pip" stands for "price interest point" and is equal to 0.01 for exchange rates expressed to two decimal places. For rates expressed to four decimal places, one pip is equal to 0.0001.

Some brokers offer an additional digit of precision for certain exchange rates. This extra digit is commonly referred to as a "fractional pip".

Buy = to take a long position. Sell = to take a short position. To close a position, you need to buy or sell an equal amount of the open order, thereby reducing the open position to zero.

Unrealized gains / losses are the profits or losses that would result if an open position were closed at the current exchange rate. Once the position is closed, gains and losses are said to be realized.

An end-of-day rollover - or rollover swap, is used by most forex brokers to close out an open position at the end of the business day. A new position is automatically created for the next business day and the net interest (interest earned minus interest paid) is calculated for the open position at the time of the rollover.

Trading Intervals in Forex

Trade Intervals

Trade intervals in this context refers to the length of time positions are held open in the account.

Because there is no standard definition, it is helpful to think of trades as falling into one of two main types intra-day trades and inter-day trades.

In Lesson 3, we looked at how most brokers use an end-of-day evaluation to determine the daily net interest for open positions. These positions are then closed and "rolled-over" into an identical position for the following day. Because day trades are closed prior to the end of the business day, day trade positions are not typically included in the interest calculation for your account.

Sample Price Chart

Intra-Day Trades

Commonly referred to as day trades, intra-day trades are opened and closed during the same business day.

The length of time intra-day trades remain open could range from just a minute or two, to several hours.

Intra-day traders hope to profit on the currency pair's volatility as exemplified in the following price chart.

Note that even though the exchange rate fluctuated continuously between 14:00 and 16:00 hours, overall, the rate declined.

In this case, taking a short position around 14:00 hours and holding it for only two hours, would have resulted in a gain of approximately 35 40 pips.

Inter-Day Trades

An inter-day trade remains open overnight. Because these trades are held over from one day to the next, they are included in the end-of-day rollover and also the interest calculation for the account.

Inter-day traders are usually employing one of the following three strategies:
o o o

Trading a long-term view Establishing a carry-trade Hedging future currency exposures

Trading a Long-Term View

A long-term view is the forming of an opinion on the future direction of an exchange rate. If you believe, for instance, that Japan's economy will contract over the next quarter, while the Eurozone countries led by industrial powerhouse Germany will expand, you might conclude that the euro will appreciate in value over the yen over the long term.

To take advantage, you could go long the EUR/JPY with the intention of holding the position open for the next two to three months, or even longer.

As time goes on and your assessment proves accurate (or not), you can close the position at any time at the current market price.

Depending on the market price, closing the position will serve to either realize your gains, or limit your losses.

Eurozone The name given to the collection of countries that use the euro as their currency.

Establishing a Carry Trade

A carry trade is used to take advantage of the interest rate differential between the two currencies in a currency pair.

The basic goal of a carry trade is to buy currencies with a high interest yield, while shorting currencies with a low yield.

For your carry trade to be profitable, your long position must yield more interest than you are forced to pay for your short position. The difference is called carry, and if the carry is positive, you profit if the carry is negative, you lose money.

In addition to earning profit on the interest rate carry, you can also profit on a change in the exchange rate. Keep in mind however, that if the rate moves against you, it could eliminate any profit you earn through the interest, so you must continually monitor your carry trades.

For more information on how forex brokers calculate interest on open orders, see Endof-Day Rollovers for Open Positions in Lesson 3.

Hedging Future Exchange Rate Exposures

A future exchange rate exposure exists when you will be required to convert your own currency to a foreign currency at some point in the future.

For instance, you could be faced with an upcoming payment that must be submitted in another currency, or you could be expecting some form of payment that will be converted from a foreign currency to your own.

Both situations include an element of risk in that you cannot control future exchange rates.

This means that your upcoming bill could cost you more than expected if your own currency loses value against the currency in which you must pay the bill.

On the other hand, if your currency gains in strength and you are expecting a future payment, it will be worth less to you once converted to your own currency.

Using Spot Forex Trades to Hedge Future Exchange Rate Exposures

To protect against an unfavorable change in the exchange rate in the future, you can enter into a spot market forex trade.

For example, a UK resident intends to buy property in the U.S. later in the year. To think of this in currency trading terms, the buyer is long GBP and short USD.

To protect against the dollar gaining on the pound before the buyer can complete the transaction, the buyer could sell GBP and buy USD, and hold this position open in a forex trading account.

This effectively "locks in" the current exchange rate as the buyer is holding USD in the trading account.

If the dollar gains in value, the buyer will receive more pounds back when the position is closed, and the extra can be used to buy USD.

On the other hand, if the dollar falls in value, the buyer will still have the equivalent when converted to USD - which is the purpose of the hedge in the first place.

A word of warning before engaging in any long-term, inter-day trading you will need to be able to withstand the normal fluctuations that will most certainly occur for any currency pair over a longer time frame. You may suffer through several days in a row where the price moves against you, but you must have the courage to stick to your strategy and remember that you are in it for the long haul. Trends are rarely in a straight line and rates will fluctuate. But, if the overall trend is in the direction you predicted, you will come out on top. If you don't think you can handle this pressure, or if you question your ability to identify such opportunities, then this form of trading may not be appropriate for you.

Forex Trading Strategies and Best Practices

Overview

The idea of listing your strategies or trading guidelines, is to create the equivalent of a "policies and procedures" manual for trading.

Defining your strategy before you enter into a trade helps prevent emotion taking over your trading.

Trading on the Technicals

"Technicals" refers to the use of charts and graphs to identify potential buy and sell levels.

Traders who employ these tools are often called "chartists" see Lesson 6 An Introduction to Technical Analysis for more information on technical trading.

Trading on the Fundamentals

Trading on the fundamentals also referred to as trading the news is the study of news events and economic statistics to determine trading opportunities.

Referred to as fundamentalists, these traders pay close attention to changes in economic indicators such as interest rates, employment rates, and inflation. See Lesson 5 A Primer to Fundamental Analysis for more information on fundamental trading.

Trading When Indicators Conflict

It is a fact of trading that there will be times when you will face conflicting information as you evaluate the likely future direction for a particular currency.

When faced with contradictory information, you have two options; 1) formulate your own opinion as to the direction the exchange rate will likely go, or 2) simply refrain from dealing in that currency pair until a clearer picture emerges.

Trading Discipline

Successful trading requires the discipline to stick to a strategy. No matter the market direction, the worst thing you can do is act rashly and without thought - this only exaggerates losses.

If you have entered into a trade based on the best analysis available to you at the time and the trade still goes against you, it may be best to cut your losses and move on.

While no trader likes taking a loss, randomly buying and selling on every market fluctuation is not a trading strategy - it is however, a sure way to lose money.

While we are on the topic of losing money, incorporating stop-losses into your orders can help protect your investment. See Stop-Loss Orders later in this lesson for more information.

When in Doubt, Don't When conflicting information prevents you from determining a clear direction, avoiding that currency pair for the time being is a perfectly valid strategy.

Forex Order Types

Overview

Most brokers offer the following order types:

o o o o

Market Orders Limit Orders Take Profit Orders Stop Loss Orders

Your trading style will dictate the order type that best suits your needs.

Market Orders

A market order is executed immediately when placed. It is priced using the current spot, or market price.

A market order immediately becomes an open position and subject to fluctuations in the market.

This means that should the rate move against you, the value of your position deteriorates this is an unrealized loss.

If you were to close the position at this point, you would realize the loss and your account balance would be updated to include the revised totals.

To prevent the executed rate from slipping too far from your intended price, OANDA fxTrade allows you to include upper and lower bounds with your market order. If the executed price falls outside these bounds, fxTrade prohibits the execution of the order. Because of the rapidly changing nature of the forex market, the executed price may differ from the last price you saw on the trading platform. This is referred to as slippage. Sometimes slippage works to your favor, and sometimes to your disadvantage.

Limit Orders

A limit order is an order to buy or sell a currency pair, but only when certain conditions included in the original trade instructions are fulfilled.

Until these conditions are met, the order is considered a pending order and does not affect your account totals or margin calculation.

The most common use of a pending order is to create an order that is executed automatically if the exchange rate reaches a certain level.

For example, if you believe that EUR/GBP is about to begin an upswing, you could enter a limit buy order at a price slightly above the market rate. If the rate does move upwards as you predicted and reaches your limit price, a buy order is executed with no further input on your part.

A pending limit order has no impact on your account totals and can be cancelled at any time without consequence. If the conditions of a limit order are met however, the pending order is executed and becomes an active market order.

Take-Profit Orders

A take-profit order automatically closes an open order when the exchange rate reaches the specified threshold.

Take-profit orders are used to lock-in profits when you are unavailable to monitor your open positions.

For example, if you are long USD/JPY at 109.58 and you want to take your profit when the rate reaches 110.00, you can set this rate as your take-profit threshold.

If the market price touches 110.00, the open position is closed by the system and your profit is secured.

Stop-Loss Orders

Similar to a take-profit, a stop-loss order is a defensive mechanism you can use to help protect against further losses.

A stop-loss automatically closes an open position when the exchange rate moves against you and reaches the level you specify.

For example, if you are long USD/JPY at 109.58, you could set a stop-loss at 107.00 then, if the exchange rate falls to this level, the trade is automatically closed, thereby capping your losses.

It is important to understand that stop-loss orders can only restrict losses, they cannot prevent losses.

It is in your best interest to include stop-loss instructions for your open positions. Think of them as a very basic form of account insurance.

Traders use the term "stopped-out" to describe the situation where a stop-loss closes a position.

GTC (Good 'til Cancelled)

GTC orders are another type of limit order that remain pending until either the limit conditions are met, or you physically cancel the order.

GTC orders do not expire and your broker will not cancel the order so you must remember that you have an order scheduled and pending until you manually cancel it.

Support Recent level at which the market has supported the price and prevented it from falling further.

GFD (Good For Day)

GFD orders are similar to GTC orders except that they are only in force until the end of the current business day.

If the limit conditions are not met, and you do not cancel the order manually, GFD orders are automatically cancelled at the end of the day as part of your broker's end-of-day processing.

Resistance Recent level at which the market has resisted a further increase in the exchange rate.

OCO (One Cancels the Other)

OCO orders are a combination of two limit orders. When one of the orders is executed, the other is automatically cancelled.

OCO orders are useful when you are unsure which direction the exchange rate may go. For example, EUR/CHF is currently trading at 1.4671. This has proven to be a level of support for the trading session.

Therefore, you enter a limit buy order at 1.4680; this is just above the current level and should get you in early on a rally.

On the other hand, should the price fall through the support level of 1.4671, you could profit on the falling price.

To prepare for this possibility, you could also enter a limit sell order at 1.4660. As a result of creating this OCO order, there are now three possible outcomes: 1. The rate climbs to 1.4680 this triggers your limit buy order and cancels the limit sell. 2. The rate falls to 1.4660 this triggers your limit sell order and cancels the limit buy. 3. The rate fails to hit either the limit buy or the limit sell within the specified time frame and both orders expire unexecuted.

Forex Training Summary and Quiz

Making First Trade

Use practice accounts to experience realistic trading scenarios without actually risking your funds.

Create a "watch list" of currencies for which you intend to specialize. Learn the factors that tend to affect the value of each currency on the list.

Intra-day trades (also known as day trades) are trades that are opened and closed within the same trading day.

Inter-day trades are trades held open overnight and remain in effect the following day. Inter-day trades are typically used to:
o o o

Trade on a long-term view Establish a carry-trade Hedge future currency exposures

Trading on a long-term view is the forming of an opinion on the expected direction of a currency pair over an extended period of time.

Carry trades are a special trading strategy designed to take advantage of an interest rate differential between two currencies in a currency pair. To profit on the difference in interest rates, you need to be long the higher-yielding currency and short the loweryielding one.

Technical Analysis is the use of charts and graphs to predict future exchange rates.

Fundamental Analysis is the study of news and economic results to predict future exchange rates.

Forex order types include:

o o

Market order - executed immediately at the current market price. Limit order - buy or sell order that is executed only when price conditions are met.

Take-Profit order - automatically closes an open position at specified rate to lock in profits.

o o

Stop-loss order - automatically closes an open position to prevent further losses. GTC order - limit order that remains pending until you physically cancel the order if not executed by the trading system.

GFD order - limit order that remains pending only until the end of the business day if not executed by the trading system.

OCO order - combination of two limit orders; if one is executed, the other order is immediately canceled by the trading system.

Beware of setting take-profit or stop-loss thresholds so close to the market price that normal rate fluctuations can trigger them.

Forex Fundamental Analysis

Fundamental analysis is the interpretation of statistical reports and economic indicators. Things like changes in interest rates, employment reports, and the latest inflation indicators all fall into the realm of fundamental analysis. Forex traders must pay close attention to economic indicators which can have a direct and to some degree, predictable effect on the value of a nation's currency in the forex market. Given the impact these indicators can have on exchange rates, it is important to know beforehand when they are due for release. It is also likely that exchange rate spreads will widen during the time leading up to the release of an important indicator and this could add considerably to the cost of your trade.

Therefore, you should regularly consult an economic calendar which lists the release date and time for each indicator. You can find economic calendars on Central Bank websites and also through most brokers

The Role of Central Bank

Overview

Most countries have some form of Central Bank serving as the principle authority for the nation's financial matters.

Primary duties for a Central Bank include:

o o o o

Implement a monetary policy that provides consistent growth and employment Promote the stability of the country's financial system Manage the production and distribution of the nation's currency Inform the public of the overall state of the economy by publishing economic statistics

Fiscal and Monetary Policy

Fiscal policy refers to the economic direction a government wishes to pursue regarding taxation, spending, and borrowing.

Monetary policy is the set of actions a government or Central Bank takes to influence the economy in an attempt to achieve its fiscal policy.

Central Banks have several options they can use to affect monetary policy, but the most powerful tool is their ability to set interest rates.

How Central Banks Use Interest Rates to Implement Fiscal Policy

A primary role for most Central Banks is to supply operational capital to the country's commercial banks. This is done by offering loans to these banks for short time periods usually on an overnight basis.

This ensures the banking system has sufficient liquidity for businesses and individual consumers to borrow money, and the availability of credit has a direct impact on business and consumer spending.

The Central Bank charges interest on the short-term loans it provides. The rate charged by the Central Bank affects the interest rate that the banks charge their customers as the banks must recover their cost (the interest they paid) plus earn a profit.

Central Banks use the relationship between the short-term rates at which it offers loans, and the interest rate the banks charge, as a way to influence the cost for the public to borrow money.

If the Central Bank feels that an increase in consumer spending is needed to stimulate the economy, it can lower short-term rates when providing loans to the commercial banks. This usually results in the banks lowering the interest they charge, making borrowing less costly for consumers which the Central Bank hopes will lead to an increase in overall spending.

If a tightening of the economy is needed to slow inflation, the Central Bank can increase interest rates making loans more expensive to acquire, which could lead to an overall reduction in spending.

Supply and Demand of Currency

Just like any commodity, the value of a free-floating currency is based on supply and demand.

To increase a currency's value, the Central Bank can buy currency and hold it in its reserves. This reduces the supply of the currency available and could lead to an increase in valuation.

To decrease a currency's value, the Central Bank can sell its reserves back to the market. This increases the supply of the currency and could lead to a decrease in valuation.

International trade flows can also influence supply and demand for a currency. When a country exports more than it imports (a positive trade balance), foreign buyers must exchange more of their currency for the currency of the exporting country. This increases the demand for the currency.

Monetary and Fiscal Policy

Common Economic Indicators
GROSS DOMESTIC PRODUCT (GDP) One of the most influential of the economic indicators, GDP measures the total value of all goods and services produced by a country during the reporting period. An increase in GDP indicates a growing economy, and for this reason, GDP is used to measure the level of inflation within the economy.

CONSUMER PRICE INDEX (CPI) Measures the cost to buy a defined basket of goods and services. It is expressed as an index based on a starting value of 100. A CPI of 112 means that it now costs 12% more to buy the same basket of goods and services today than it did when the starting index value was first determined. By comparing results from one period to the next, it is possible to measure changes in consumer buying power and the effects of inflation. Inflation is a concern to currency traders as it affects the price of everything bought and sold within an economy, and this has a direct impact on the supply and demand for a country's currency.

Inflation is an increase in the price of goods and services. While inflation by its very definition suggests economic growth, inflation that occurs too rapidly actually weakens consumer buying power as prices increase at a faster rate than salaries. PRODUCER PRICE INDEX (PPI) Also an inflation indicator, the PPI tracks the changes in prices that producers receive for their products. Expressed as an index relative to 100. Excludes volatile items such as energy and food to avoid distorting the index. By measuring the prices received by domestic producers, it is possible to project how the consumer-level prices could be affected.

EMPLOYMENT REPORTS Employment reports have an immediate impact on currencies because employment levels directly affect current and future spending habits. An increase in unemployment is a negative indicator as it implies that more people are not receiving a regular salary. This is a sure signal that consumer spending will decline. The following table lists some of the most important labor reports by country:

List of Employment Reports by Selected Country

Country
Australia

Report Name Wage Price Index

Labor Force Survey

Description Measures changes in wages. Provides a snapshot of current employment rates and a breakdown of employment by sector. Provides a study of U.S. employment statistics

Canada

United

Non-Farm Payroll (NFP)

States

for all workers except:

o o o

Those employed on farms or in private homes Those employed by non-profit organizations Those employed by the government.

Unemployment Insurance Initial Claims

Tracks the number of new unemployment insurance claims for the reporting period. Determines the change in Unemployment Insurance claims from one reporting period to the next.

United Kingdom

Claimant Count Change

INTEREST RATES Most Central Banks maintain a "benchmark" interest rate. Depending on the jurisdiction, the Central Bank rate serves as the guide for the rate at which the Central Bank and other commercial banks lend each other funds to meet short-term operational needs. Commercial lending rates are also affected by the Central Bank rate, and it is this linking of short-term rates to the commercial rates that makes interest rate policy the primary monetary tool for Central Banks. As noted earlier, the Central Bank can increase rates during periods of high growth (inflation) in a bid to reduce consumer spending which should help bring growth back to a more manageable level. If deflation is a problem and the economy needs a boost, Central Banks can lower interest rates to entice more consumer lending. The expected outcome is that overall consumer spending will increase as consumers have access to less costly loans. Forex traders in particular pay close attention to changes in interest rates as investors tend to seek out currencies offering higher returns and this demand can cause a currency to appreciate. Also, the greater the interest rate differential between two currencies, the greater the profit potential of a carry trade strategy. See Trading Strategies and Best Practices in Lesson 4 for more information on carry trades.

YIELD CURVE Yield is the interest on fixed-income securities which includes such investments as futures contracts and government bonds.

Referred to as "fixed" income because the payment stream (the yield) remains constant until maturity. For example, a simple 5-year bond with a 3 percent annual yield, would pay $300 a year for the next five years on an initial $10,000 investment. The yield curve shows the relationship between the yield, and the time to maturity. When dealing with fixed-income securities, investors want to ensure that the fixed yield remains profitable right up until maturity. As an investor you may be happy with a 5 percent return when the basic lending rate is 2 percent. However, if short-term interest rates rise and the lending rate jumps to 6 percent, your 5 percent return is no longer so attractive, and there are probably other options that could generate more income for your investment. Liquidity spread is the term used to describe the difference between the yield and short-term rates. If short-term interest rates rise above the fixed yield, the bond holder is said to be in a position of negative liquidity spread. When plotted on a chart, the yield is represented along the y-axis, while time to maturity is charted vertically on the x-axis. This results in a yield curve shape that some investors suggest offers insight into future interest rates. Consider the following so-called "normal" yield shape:

U.S. treasury bills - or "T-bills" - are a form of debt issued by the U.S. government. The maximum maturity is one year, but the 3-month T-bill is a popular choice for short-term investment. Unlike bonds that pay a regular, fixed-rate amount, T-bills are sold at a discount to par (the "face" value). At maturity, the buyer receives the full face value of the T-bill. For example, if an investor buys $10,000 worth of T-bills for $9,900, at maturity, the investor receives $10,000. The difference - $100 in this case is the yield earned by the investment. Normal Yield Curve

The normal yield curve shifts upwards over time. This pattern indicates an increase in the yield (the yaxis) as time to maturity (the x-axis) increases. This follows the tenant of the Arbitrage Pricing Theory which states that the longer the term, the higher the yield. This is based on a practice that rewards investors willing to lock their money into long-term bonds, despite the increased risks associated with a diminishing liquidity spread. Flat Yield Curve

A flat yield curve results when the yields are basically the same for all maturities. This indicates that investors are willing to accept yields on long-term instruments that do not include a premium above current short term yields. Investors would only accept this if they feel that the economy has little capacity for growth combined with the likelihood that short-term interest rates will remain stable. Inverted Yield Curve

An inverted yield curve that slopes downwards over time indicates a negative outlook for the market in the future. This could suggest the onset of a prolonged economic downturn or possible recession. An inverted yield curve shows even greater long-term pessimism than a flat curve so much so that long-term bond yields actually fall below short-term yields (negative liquidity spread). The implication is that investors believe that long-term will fall in the face of a worsening economy. Humped Yield Curve

A humped curve occurs when both short and long-term yields are equal, but medium-term yields are higher. This could indicate an expectation that the economy may be entering a period of growth, but this growth is not expected to be sustainable over the long-term. INSTITUTE OF SUPPLY MANAGEMENT (ISM) The ISM report is another inflation indicator. It measures the level of new orders and helps predict manufacturing activity for the upcoming period. It is expressed as an index based on 50. A number less than 50 means that manufacturing has contracted from the previous period, while a number greater than 50 indicates growth for the previous period. Because the ISM captures current factory production levels, it provides insight into the expected level of consumer demand for goods in the immediate future.

RETAIL SALES REPORT The Retail Sales Report tracks consumer spending patterns items such as health care and education are not included. An increase in the Retail Sales Report is likely to be seen as positive for the currency as it suggests growing consumer confidence.

INDUSTRIAL PRODUCTION INDEX (IPI)

Shows the monthly change in production for the major industrial sectors including mining, manufacturing, and public utilities. Considered an accurate assessment of employment in the manufacturing sectors, average earnings, and overall income levels. An increase in IPI suggests continued growth which is seen as a positive for the economy.

COMMODITY PRICE INDEX (CPI) Tracks the changes in the average value of commodity prices such as oil, minerals, and metals. This index is particularly relevant for countries like Canada and Australia (known as the "commodity dollars") that serve as major commodity exporters. For commodity exporters, an increase in this index suggests greater potential for earning higher prices from these exports.

TRADE BALANCE Compares the total value of imports to the total value of exports for a reporting period. A negative value indicates that more goods were imported than were exported (a trade deficit) while a positive trade balance means that exports exceeded imports (a trade surplus). If the balance of trade shows a surplus or declining deficit, then there may be an increased demand for the currency. If the report shows a growing deficit, then the increased supply together with a decrease in demand for the exporting currency could lead to a devaluation against other currencies.
PUTTING IT ALL TOGETHER

Forex Training Summary and Quiz

Forex Fundamental Analysis

Fundamental analysis is the study of economic indicators in an attempt to predict future market conditions.

Also referred to as news events, these items tend to have a predictable effect on currencies.

Central Banks are responsible for implementing monetary policy designed to meet the fiscal policy objectives of the government.

The ability to influence short-term interest rates - which have a corresponding relationship to commercial interest rates - is the primary monetary tool available to Central Banks.

Economic calendars list upcoming data releases as well as the results expected.

COMMON ECONOMIC INDICATORS

Indicator Name Gross Domestic Product

How the Indicator Affects the Currency Strong GDP results indicate a healthy economy, suggesting that the currency may increase in value compared to currencies for countries with weaker economies. A CPI that continues to trend upwards month over month could be a signal that inflation is eroding buying power to the point that the Central Bank will raise interest rates to curb spending. An increase in interest rates may lead to an increase in demand for the currency as the potential for a higher return makes the currency more attractive for investors. If employment trends downwards, the economy could weaken as fewer people will have the means to purchase non-essential goods. If employment is increasing, then spending is likewise expected to increase, and a stronger economy often leads to a stronger currency. Investors naturally look to currencies that provide the best return. If interest rates rise for a particular currency, investors will increase their holdings in that currency to profit on the higher return. The resulting increase in demand for the currency could cause it to appreciate in value compared to other currencies. Because the yield curve is seen as an indicator of future interest rates, its impact on currency values is much the same as that of interest rates in general. Like other inflation-based reports, increasing PPI values could signal an interest rate hike to combat inflation. Interest rate increases can lead to a greater demand for the currency. Also tracks inflationary pressures in the economy. An ISM trending upwards can suggest a growing economy, which makes the currency attractive to

Consumer Price Index

Employment Reports

Interest Rates

Yield Curve

Producer Price Index Institute of Supply

Management Retail Sales Industrial Production Index Commodity Price Index

forex traders. A stronger Retail Sales report indicates overall growth in the economy, thus increasing the currency's appeal to investors. A positive or increasing IPI suggests continued economic growth, which often leads to a stronger currency. An increase in the Commodity Price Index means that commodities are generating more income for the economy, which often leads to an appreciation in the country's currency. The Trade Balance Report provides insight into the demand for a currency on the global markets. If the balance of trade shows a surplus or declining deficit, then there may be an increased demand for the currency. If the report shows a growing deficit, then the increased supply of the currency could lead to a devaluation against other currencies. Current Account deficits can have a negative impact on the currency for the same reasons cited for Trade Balance deficits. When in a deficit situation, a country is forced to convert its own currency to the currencies of other countries. This increases the supply of currency, resulting in a potential devaluation against other currencies.

Trade Balance

Current Account

Forex Technical Analysis

Technical analysts track historical prices and traded volumes in an attempt to identify trends. They use graphs and charts to plot this information, and for this reason are sometimes referred to as chartists. By attempting to quantify historical performance, technical analysts seek to identify repeating patterns as a means to signal future buy and sell opportunities. The field of technical analysis is based on three important assumptions: 1. The price of a security automatically factors in economic conditions. Technical analysts believe that the impact of events such as interest rate changes or the latest inflation reports are automatically factored into the currency price through the natural actions of buyers and sellers within the market. 2. When it comes to pricing, history tends to repeat itself.

Technical analysts believe that prices move in trends and price movements generally follow established patterns that can be partly attributed to market psychology (or, more euphemistically, "herd mentality"). Market psychology is based on the widely-held belief that participants in markets, who for the most part have the same goals and objectives, react in a similar fashion when faced with similar situations. 3. Once established, trends tend to continue. Technical analysts look for trends as a way to predict future prices. There are three selfexplanatory trends:
o o o

Up-trend Down-trend Sideways / horizontal trend

Technical analysis continues to evolve, and most trading platforms offer a host of tools to automate the calculations required to plot prices. We will review some of the more popular technical tools in the following sections.

Candlesticks Formation in Forex

Overview

Candlesticks can pack more information into a single view than any other form of price chart. For this reason, they remain a perennial favorite with many traders.

The history of candlestick charts can be traced back to 18th century Japan where candlesticks were used by buyers and sellers in the rice markets.

Candlesticks are similar to bar charts and provide opening and closing values, current direction trends, and the high and low price for each reporting period.

The body length of the candlestick shows the relative change in the open and close rates for the reporting period the longer the body, the more volatile the swing between the open and close rates. The color of the candlestick body provides key information. A hollow candlestick means that the bottom of the body represents the opening rate, while the top shows the closing price. A filled candlestick, on the other hand, shows the opening rate at the top of the body and the closing rate at the bottom. Therefore, a hollow candlestick shows a rising trend, while a filled candlestick points to a decreasing trend.

Sample Candlestick chart COMMON CANDLESTICK PATTERNS Candlestick patterns are seen by some traders as a form of rate direction signal. The following list includes some of the more popular patterns, and explains how to interpret the signal. Doji Patterns

A doji occurs when the opening and closing prices are basically the same price, resulting in a very small body. Note that the length of the upper and lower shadows (which reflect the intra-period prices) have no effect on the closing price. The interpretation of the basic doji is that there is no clear direction for the market. This should make you wary until a stronger indication presents itself.
Gravestone Doji

When the open and the close prices occur at the low of the reporting period, they create a gravestone doji. This pattern can signify that the top of the market (the resistance level) has been reached as there are no buyers willing to advance the price further so prices may start to reverse.

Long-legged Doji

When the open and close prices occur at the top of the reporting period, the result is a longlegged doji. This pattern suggests that the market has reached the support price, and a reversal is likely.
Two-Candlestick Patterns

Spinning Tops

Spinning tops consist of candlesticks with a small body that can be either hollow or filled. The small bodies indicate that for the reporting period, there has been very little difference between the opening and closing prices. For this reason, spinning tops are seen as a sign of indecision pointing to the increased likelihood of a market reversal.
Hammer and Hanging Man

Both these patterns have long lower shadows, but very small bodies and a very small or no upper shadow. They both suggest price uncertainty and you should look for confirmation that a price reversal is about to take place before acting. If the pattern appears at the bottom of a downtrend (hollow body), it is referred to as a hammer. If it appears at the top of an uptrend (filled body), it is known as a hanging man.
Three-Candlestick Patterns

Morning and Evening Star

The morning star indicates that the price has reached a support level after a declining market. It appears as a small hollow-bodied candlestick that follows a declining, filled candlestick marking a turning point in the price. It is confirmed by a third candlestick showing a dramatic price increase. Whereas the morning star is an optimistic signal, the evening star is a pessimistic signal that occurs at the end of a downward trend. It appears as a candlestick with a very small body that appears just before a major decline in prices.
Shooting Star

A shooting star is a strong signal that a price run-up is about to come to a crashing halt. This is the pattern you should be on the look-out for after a prolonged price increase, and is capped by a candlestick with a small hollow body. This "shooting star" clearly shows the market is pausing to reflect on the current price runup.
FIBONACCI RETRACEMENTS