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Frustrated trader? Here's a forex primer

Wed, Jun 28 2006, 14:50 GMT
by Darrell Jobman

Market Technologies, LLC

Tired of the vagaries of stocks or the volatility of futures such as energy or gold? Then you might be a candidate for the largest traded "market" in the world. It’s not the U.S., Japanese or European stock markets but the foreign exchange – or forex or just FX – market, also called the cash currency market.

Speculators can and do trade this huge market, where nearly $2 trillion can change hands every day, far exceeding the amount traded on all of the world’s stock exchanges combined. Traders and speculators in the spot market account for about 37% of the forex activity with another 43% involved in swaps and 20% in options and forwards.

The main function of the foreign exchange market is to provide the mechanism for making cross-border payments and determining exchange rates between currencies. A forex trade is executed through the simultaneous buying of one currency and selling of another (currency pair). Although most currencies are tradable, the U.S. dollar and four other currencies account for most of the forex trading volume: Euro ( EUR/USD), Yen (USD/JPY), British pound or cable (GBP/USD) and Swiss franc (USD/CHF) (see Figure 1).

Forex is the ideal market for experienced traders who have paid their "trading tuition" in other markets. Forex trading involves no commissions – only point spreads measured in “pips,” equal to one-tenth of one percent (0.01%). Because the point spread in pips represents the cost of entry, it is desirable to keep it to a minimum and explains why forex trading is concentrated in the major currency pairs, which have the tightest spreads, often as low as three or four pips.

Spot currency trading lots typically are worth $5 million to $10 million, with the minimum contract size $500,000. Smaller amounts may be traded with some firms offering minimum investments of as little as a few hundred dollars on margin far exceeding 100:1. However, this is extremely risky and, therefore, not recommended.

Technical advantages

Of all financial instruments traded, forex may be the best suited for technical analysis for a number of reasons:

1. Forex dwarfs all other markets in trading volume. Forex trading has grown some 2,000% over the last three decades, rising from barely $1 billion per day in 1974 to an estimated $2 trillion by 2005, so there is plenty of turnover to produce liquidity.

2. Forex markets never close during the trading week so there is no build-up or backlog of client orders overnight or pent-up reaction to news stories hitting the market at the open. This means no gaps that can create instant losses (or gains) for those holding positions overnight. The trading week begins in Sydney, Australia, on Monday while it is still Sunday in North America and Europe and ends in New York on Friday afternoon so you can trade in the middle of the night or whenever you want.

3. There are two basic types of markets: trending and trading-range markets. It is far easier to make money in trending markets. Currencies tend to experience longer-lasting trends that can continue for months or even years. This makes them ideal vehicles for trend-trading and breakout systems and explains why chart pattern analysis works so well in forex trading. With such widespread groups playing the game around the world, crowd behavior plays a large part in currency moves, and it is this crowd behavior that is the foundation for technical analysis tools and techniques.

4. Due in part to its size, forex is less volatile than other markets. Lower volatility equals lower risk. For example, the S&P 500 Index trading range is between 4% and 5% daily, while the daily volatility range in the Euro is around 1%.

5. Forex is an ideal market for the “intermarket" method of market analysis developed many years ago by respected industry professional Louis B. Mendelsohn. Trading veterans know that markets are interdependent, with some markets more heavily influenced by certain markets than others. Mendelsohn's VantagePoint analytical software detects hidden, yet repeating, patterns that occur between related markets. By using neural networks to analyze data from a number of related markets (see Figure 2), the software projects moving averages that lead the turns in actual moving averages (see Figure 3) with a success rate of about 80%.

Don't forget fundamentals

Like their commodity and stock counterparts, successful forex traders also can’t forget about the fundamentals that influence the forex market.

1. Interest rate announcements by central banks and even the tone of the language in meeting minutes published following announcements or rate change decisions.

2. Government debt and deficit figures that show changes for the better or worse. Increasing deficits, for example, often portend an increase in interest rates as the government competes with the private sector for investment capital. The difference between stocks and forex is that increasing rates are usually good news for a currency.

3. Quarterly reports of gross domestic production (GDP). Preliminary national GDP announcements also have the potential to affect market sentiment.

4. Economic or geopolitical events such as elections, armed conflicts. political uprisings, etc. – anything that investors or traders think may destabilize or impact the market.

5. Reports such as the Institute of Supply Management Index in the United States and the Purchasing Management Index in Europe tend to be closely watched by traders.

6. Industrial production figures, jobs (non-farm payrolls in the U.S.) and employment figures can impact markets including currencies because they could have a direct bearing on national interest rate and economic policy.

7. Yen traders closely follow Japanese reports such as the Tankan quarterly survey for insights into currency movement.

8. Market sentiment surveys published by market commentators and news services. It is often a good idea to buy on rumour, sell on news.

Forex traders must use all of the trading tools at their disposal. The better these fundamental and technical tools are, the greater their chance for trading success. Although intermarket and other relationships are often complex and difficult to apply effectively, with a little high-tech help, traders and investors can enjoy the benefits of using them without having to scrap their existing trading methods.

Who is Darrell Jobman

Darrell Jobman, Senior Market Analyst for www.TradingEducation.com, is an acknowledged authority on financial markets and has been writing about them for more than 35 years.

Published on  Fri, Sep 8 2006, 09:58 GMT