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The Spot Market

Thu, Jun 29 2006, 09:00 GMT
by Andy Shearman

Trader House Network

Summary

1. Introduction
2. Currency pairs and the rate of exchange
3. Buying equals selling
4. Practical spot trading
5. Worked examples
6. Controlling risk
7. Screen-based spot trading
8. Fundamental and technical analysis
9. Tips for aspiring spot traders

Appendix A

1. Introduction

The spot market accounts for nearly a third of global foreign exchange turnover. It can be broadly divided into two tiers:

• 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).

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.

2. Currency 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.

3. Buying equals selling

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 1.5550 USD.

We can express this equivalence by inverting the GBP/USD exchange rate and rotating the bid and offer reciprocals, to derive the USD/GBP rate i.e.

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 points.

4. Practical spot trading

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 mini-lots).

• 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.

4.2 Margin
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 level.

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 rate.

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. Worked examples

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 account

• 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 loss.

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 of:

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, however, is:-

100,000 X 1.6005 USD = 160,050 USD

Your “shortage in equity” is therefore 160,050 USD - 95,270 USD= 64,780. 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.

6. Controlling risk

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 threshold.

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 price.

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 account holder.

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 cancelled.
 

7. Screen-based spot trading

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 administrative functionality.

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 connection
• A computer terminal capable of running several programmes simultaneously
• 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 (www.traderhouse.net).

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 simultaneously.

We will return to the tools of technical analysis in the next section.

8. Fundamental 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 power parity”.

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 exchange.

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 apparent.

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 exchange rates.

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.

8.2.1 Charts

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.

8.2.2.1 Support
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”.

8.2.2.2 Resistance
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 resistance.


8.2.2.3 Channels are identified by superimposing support and resistance levels on a single line chart. Channels can slope upward, sideways or downward.


8.2.2.3 Triangles
Where resistance and support lines converge towards to one another over time, “triangles” are formed which can be upward, sideways or downward sloping.

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.

8.2.3 Indicators

8.2.3.1 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 trend.

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.

8.2.3.2 Stochastic oscillators
Stochastic oscillators are momentum indicators that purport to tell you when to buy or sell. They are composed of two elements:

• 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 of %K. A rise in %K rises over %D is interpreted as a buy signal, and vice versa.

When the oscillator touches 80, the currency is considered overbought. An oscillator below 20 is considered to indicate an oversold currency.

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 opportunities.
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 every day.
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!

Appendix A

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

Published on  Thu, Jun 29 2006, 04:00 GMT

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