Profit and Loss

Table 6.3 allows you to see your profit or loss in dollars for various pip amounts and lot sizes. A micro-lot is 1,000 (1k) Units; a mini-lot is 10,000 (10k) Units; a standard lot is 100,000 (100k) Units; a bank lot is 250,000 (250k) Units. Some of these have been rounded off to make easier reading; they are close enough to serve the purpose for a quick in-trade status check.

Margin

Margin-per-trade is the amount of dollars you must put into play to control a larger amount of currency pair. Margin is a bit of a misnomer in FOREX. If you open a trade on a 100,000 lot of EURUSD and the broker requires $2,000 to accept the trade, your margin is $2,000. Brokers do set maximum margins. If you have multiple open positions your margin is the sum total of all of them; this is your aggregate margin. See Table 6.4.





















TABLE 6.3 Profit and Loss













TABLE 6.4 Margins















TABLE 6.5 Leverage

Leverage Leverage is margin-per-trade quoted as a ratio. In the above example, leverage is 50:1 (100,000/2,000). The higher the ratio, the higher your profit (or loss) potential.

As you can see in Table 6.3, on a 100,000 lot a pip is worth $10. With leverage at 50:1 if prices go for (or against) you by 200 pips, you have made (or lost) your entire margin of $2,000, a 100 percent profit (or loss). See Table 6.5 for profit or loss in dollars of margin against different leverage ratios.

The Bid-Ask Spread

FOREX prices are always quoted in the form of Bid-Ask-Last Trade. If you are a potential buyer, the Ask is the price someone will sell to you. If you are a potential seller, the Bid is what someone is willing to buy from you. You Buy the Ask and Sell the Bid in FOREX.

Market-maker brokers add their transaction costs to this bid-ask spread. By knowing how many pips are in the spread you are able to calculate your costs for the trade, exclusive of any other factors such as slippage, commissions, or rollover costs. Typically only ECNs charge commissions and, therefore, their bid-ask spreads are tighter. Bid-ask spreads typically range from 0 pips to 10 pips in most pairs but can balloon much higher during fast markets and slow markets, as well as before, during, and after news releases. The information in Table 6.6 is given for the purpose of calculating the dollar value of the bid-ask spread and, if you trade with a market maker, the majority of your cost to trade that currency pair.

Pips

A pip is the smallest price increment that any currency pair can move in either direction. In the FOREX markets, profits are calculated in terms of pips first, then dollars second. See Tables 6.1 and 6.2. The conversion of pips to dollars may be considered the base FOREX calculation. Calculate that against your lot size and you are halfway home already.

Approximate USD values for a one-pip move per contract in the major currency pairs are shown in Table 6.2, per 100,000 units of the base currency. TIP: On a typical day, actively traded currency pairs like EUR/USD and USD/JPY may fluctuate 100 pips or more. Table 6.2 is based on a margin requirement of 100 percent (leverage = 1:1). To calculate actual profit (or loss) in leveraged positions, multiply the pip value per 100k times the leverage ratio (margin percentage divided by 100).

Note that the EUR/GBP cross rate pair in Table 6.2 uses multiplication with the USD spot price instead of division. This is because the USD is the quote (second) currency in the spot conversion pair.



















TABLE 6.1 Single Pip Values















TABLE 6.2 Full Lot Pip Values

Trading Tables

FOREX is truly a numbers game with pips, dollars, lot size, stop-loss, takeprofit, leverage, margin, profit and loss, transaction costs, and more to know. Separately they are not difficult to understand but the interrelationships involving various mathematical formulas, ratios, decimals, and fractions can be difficult to master. For example, the pip amount of your take-profit divided by the pip amount of your stop-loss is the profit-to-loss ratio. It, in turn, is closely related to the ratio of winners to losers over a fixed number of trades. The new trader has a big plate, as is, even before considering these myriad mathematical mechanizations.

All of the mechanics are important and worth knowing. But I have found over years of mentoring new traders that they are best learned by practice. Your broker’s trading platform and/or tools on their web site should allow you to calculate most of these values. Simply using your demo account diligently can, over time, make most of these clear to you. As you calculate the values make an effort to see the relationship between each of the numbers, essentially reverseengineering them.

TIP: All calculations involve two or more factors. Change only one of them at a time, up and down, and see how they affect the others. Excellent calculation tools are available on www.goforex.net, www.forexcalc.com, and www.oanda.com.

For those who have a penchant for math, I have included most of the key calculations with examples in Appendix G. For those who do not, I offer Trading Tables. These are the key calculations and ratios you should know for getting started. Most of them are related to converting pips to dollars, profit and loss, and money management. In Chapter 16, “Money Management Simplified,” you learn how to put these tables to good use. You can use these computer-side as you trade. All of them are available for download from the Getting Started section of www.goodmanworks.com.

For the Trading Tables, pip values have been rounded off slightly in some cases to make them easier for the student to use.

Quote Convention

Exchange rates in the FOREX market are expressed using the following format:

Base Currency/Quote Currency Bid/Ask

Examples can be found in Table 5.1.
Normally only the final two digits of the bid price are shown. If the ask price is more than 100 pips above the bid price, then three digits will be displayed to the right of the slash mark (that is, EUR/CZK 32.5420/780). This only occurs when the quote currency is a weak monetary unit.











TABLE 5.1 Examples of Quote Convention

Market Maker and ECN

Retail brokers are of two types, although some gray areas, terms such as liquidity provider and No Dealing Desk (NDD), have appeared recently.

A market maker is the counterparty to each transaction. In effect, they are acting as their own mini-exchange. At one end market makers are tapped into the Interbank market—often indirectly—and at the other end are the retail customers. What goes on in-between could be a book unto itself.

An Electronic Communications Network (ECN) broker is simply a matchmaker. They also have liquidity providers at one end—usually banks, sometimes other ECNs—and clients at the other. An ECN simply matches orders.

Transaction Cost

The critical characteristic of the bid-ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. In the case of the EUR/USD rate as seen earlier in Table 5.1, the transaction cost is three pips. The formula for calculating the transaction cost is:

Transaction Cost = Ask Price - Bid Price

In FOREX you buy the ask and sell the bid. You offset a trade by closing the trade, not executing the opposite action—buy if you are short, sell if you are long.

Market-maker brokers add their profit into the spread. Electronic Communication Network brokers (ECNs) charge a small commission per lot.

Rollover

Rollover is the process where the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies. Rollover cost is not significant for the short-term trader but impacts cost for the long-term trader who might hold a position for several days. If you intend to do long-term trading, be sure to shop rollover costs among several broker-dealers.

Summary

Trading currencies on margin lets you increase your buying power. If you have $2,000 cash in a margin account that allows 100:1 leverage, you could purchase up to $200,000 worth of currency because you only have to post 1 percent of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power.

With more buying power, you can increase your total return on investment with less cash outlay. To be sure, trading on margin magnifies your profits and your losses.

A detailed description on how to calculate profit and loss of leveraged trades occurs in Appendix G, “FOREX Calculation Scenarios.”

Bid Price Ask Price

Bid Price

The bid is the price at which the market is prepared to buy a specific currency pair in the FOREX market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation. For example, in the quote USD/CHF 1.4527/32, the bid price is 1.4527, meaning that you can sell one U.S. Dollar for 1.4527 Swiss Francs.

Ask Price

The ask is the price at which the market is prepared to sell a specific currency pair in the FOREX market. At this price, the trader can buy the base currency. It is shown on the right side of the quotation. For example, in the quote USD/CHF 1.4527/32, the ask price is 1.4532, meaning that you can buy one U.S. Dollar for 1.4532 Swiss Francs. The ask price is also called the offer price.

Bid-Ask Spread

The spread is the difference between the bid and ask price. The “big figure quote” is the dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be 117.30/117.35, but would be quoted verbally without the first three digits as “30/35.” You buy the ask and sell the bid.

TIP: Be sure you know to what accuracy your broker provides currency quotes. Many now quote in fractional (1⁄10) pips. This may be referred to as “Four Digit Pricing” and “Five Digit Pricing.”

Margin

When an investor opens a new margin account with a FOREX broker, he or she must deposit a minimum amount of monies with that broker. This minimum varies from broker to broker and can be as low as $100 to as high as $100,000.

Each time the trader executes a new trade, a certain percentage of the account balance in the margin account will be earmarked as the initial margin requirement for the new trade based on the underlying currency pair, its current price, and the number of units traded (called a lot). The lot size always refers to the base currency. An even lot is usually a quantity of 100,000 units, but most brokers permit investors to trade in odd lots (fractions of 100,000 units). A mini-lot is 10,000 units and a micro-lot is generally considered to be 1,000 units. A standard lot is 100,000 and a bank lot is 250,000 units.

For U.S. retail FOREX traders the minimum margin has been set by the NFA to 1 percent (100:1 leverage) for major currency pairs and 4 percent (25:1 leverage) for exotics.

Leverage

Leverage is the ratio of the amount used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a security with a comparatively small amount of capital. Leveraging varies dramatically with different brokers, ranging from 10:1 to 400:1. Leverage is frequently referred to as gearing. Typical ranges for trading are 50:1 to 100:1. The formula for calculating leverage is:

Leverage = 100/Margin Percent

The most typical leverage used by traders in retail FOREX is 50:1 to 100:1. Some brokers offer up to 400:1. A new trader should start with very low leverage, perhaps 20:1 and certainly no higher than 50:1.

To some extent FOREX traders set their own leverage insofar as they determine the lot size to trade. But your broker-dealer will set a maximum.

Margin Calls

Nearly all FOREX brokers monitor your account balance continuously. If your balance falls below 4 percent of the open margin requirement, they will issue the first margin call warning, usually by an online popup message on the screen and/or an e-mail notification. If your account balance drops below 3 percent of the margin requirement for your open positions, they will issue a second margin warning. At 2 percent, they will liquidate all your open trades and notify you of your current account balance. These percentages may vary from broker to broker. You may not even be able to execute a trade that exceeds certain capital and risk parameters. Brokers today are able to closely watch customer accounts to prevent them from getting to the point of requiring a margin call. You can be assured that as a new customer your account will be initially monitored with higher precision until the broker has a sense of how you trade.

The FOREX Lexicon

As in any worthwhile endeavor, each industry tends to create its own unique terminology. The FOREX market is no different. You, the novice trader, must thoroughly comprehend certain terms before making your first trade. As your eighth-grade English teacher taught you in vocabulary class—to use them is to know them.

Currency Pairs

Every FOREX trade involves the simultaneous buying of one currency and the selling of another currency. These two currencies are always referred to as the currency pair in a trade.

Major and Minor Currencies

The seven most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, and AUD) are called the major currencies. All other currencies are referred to as minor currencies. The most frequently traded minors are the New Zealand Dollar (NZD), the South African Rand (ZAR), and the Singapore Dollar (SGD). After that, the frequency is difficult to ascertain because of perpetually.

Cross Currency

A cross currency is any pair in which neither currency is the U.S. Dollar. These pairs may exhibit erratic price behavior since the trader has, in effect, initiated two USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. The three most frequently traded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY.

Exotic Currency

An exotic is a currency pair in which one currency is the USD and the other is a currency from a smaller country such as the Polish Zloty. There are approximately 25 exotics that can be traded by the retail FOREX participant. Liquidity—the ability to buy and sell without substantial pip spread increases; a willing buyer or seller is always available at or near the last price—is not good. Whereas a EUR/USD pair may be traded at two pips at almost any time, the EURTRY may balloon to 30 pips or more during the Asian session. changing trade agreements in the international arena.

Base Currency

The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215. In the FOREX markets, the U.S. Dollar is normally considered the base currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The exceptions are: the British Pound, the Euro, and the Australian Dollar. If you go long the EUR/USD, you are buying the EUR.

Quote Currency

The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency. If you go short the EUR/USD, you are buying the USD.

Pips

A pip is the smallest unit of price for any foreign currency. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit, that is, EUR/USD equals 1.2812. In this instance, a single pip equals the smallest change in the fourth decimal place, that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equals 1⁄100 of a cent.

One notable exception is the USD/JPY pair where a pip equals $0.01 (one U.S. Dollar equals approximately 107.19 Japanese Yen). Pips are sometimes called points.

Ticks

Just as a pip is the smallest price movement (the y-axis), a tick is the smallest interval of time (the x-axis) that occurs between two trades. When trading the most active currency pairs (such as EUR/USD or USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second. When trading a low-activity minor cross pair (such as the Mexican Peso and the Singapore Dollar), a tick may only occur once every two or three hours.

Ticks, therefore, do not occur at uniform intervals of time. Fortunately, most historical data vendors will group sequences of streaming data and calculate the open, high, low, and close over regular time intervals (1-minute, 5- minute, 30-minute, 1-hour, daily, and so forth). See Figure 5.1. Pips are a function of price; ticks are a function of time. Any location on a chart is effectively a Cartesian coordinate of Price, read vertically from bottom to top and Time, read horizontally from left to right.

















FIGURE 5.1 Pip-Tick Relationship

NFA Compliance Rule 2-43

The regulation that has dropped on the industry like a bomb is NFA Compliance Rule 2-43. Although 2-43 addresses many issues, the two most important are Anti-Hedging and FIFO.

Anti-Hedging Anti-hedging has been the most controversial new regulation. It has, in many ways, turned the retail FOREX business on its head—at least for the moment. Traders are prohibited from entering and brokers are prohibited from accepting orders that would place a trader on both sides (buy and sell) of any currency pair. Traders use speculative hedging for a wide

range of trading and money management functions, including the popular news trading technique and multiple time-frame systems.

FIFO (First In First Out) Related to anti-hedging, FIFO changes the manner in which open orders are ledgered and closed. Orders entered first must be closed first. Again, this substantially upsets the applecart for many traders, especially those who are short-term traders, those who tier in positions, and those

Price Adjustments Brokers are prohibited from canceling customer orders except under certain conditions. Price adjustments to filled orders may only be made for specific, limited reasons. This part of Rule 2-43, while unpopular with brokers, is generally accepted as positive by traders.

Capital Requirements for Retail FOREX Broker-Dealers Broker-dealers in retail FOREX must meet higher and higher capital requirements. As predicted in the first edition and began in the second edition, mergers are now common in retail FOREX. Small firms, both good ones and bad ones, are getting shut out. who use automated trading systems.

The CFTC Reauthorization Act of 2008 increases the adjusted net capital requirement for certain counterparty FCMs to $20 million. This requirement was phased in; it is a quantum leap from the previous $5 million. A counterparty FCM is generally considered to be a market maker—a broker-dealer who trades as counterparty to their customers. The author predicts the entire counterparty paradigm will be revisited by the CFTC and NFA soon. Introducing Brokers (IB) who coattail on an FCMs capital base are now also required to meet minimal capital requirements of their own.

Recently, a small broker-dealer with good customer support was shut out by this regulation and, as I write, is looking for a new FCM sponsor. I can hear the conversation with a prospective FCM’s CEO: “Sir, we offer our customers terrific customer service. It is the touchstone of our business model.” “Go away, kid.” Regulations often have unintended consequences.

Registration of FOREX Money Managers The NFA has proposed to the
CFTC that every FOREX money manager must register as a Commodity
Trading Advisor (CTA) in the same manner and with the same process as
those who manage money in commodity futures.

It is assumed the CFTC will oblige, but final regulations, at the time of this writing, have not been passed or implemented. Nonetheless, most retail FOREX broker-dealers are now requiring that money managers who work with their customers must go ahead and register as a CTA. It is possible that FOREX money managers who have been in business for a certain number of years might be grandfathered—but no one is counting on this. It is likely that exemptions from registration similar to those for commodity futures CTAs will stand. The most important of those are: (1) your primary business is not that of a CTA and you do not hold yourself out to the public as a CTA, and (2) you manage fewer than 15 accounts.

To provide for the new registration requirements a separate test has been created, the Series 34 examination. FOREX CTAs will be required to pass the Commodity Futures Series 3 examination as a prerequisite. Again, at the time of this writing, final rules have not been released.

As mentioned earlier, many brokers—including the majors—are affiliating with overseas broker-dealers who are not obligated to comply with NFA and CFTC regulations. One broker told me that two of their best money managers will leave if they are required to register as a CTA. File this one also in the unintended consequences folder. As a former CTA I can attest that regulation is an expensive proposition. If you manage $20 million per year, $100,000 to meet all the requirements to sustain an audit is doable. If you manage $2 million, it makes no sense at all.

TIP: This bears some watching because it involves a small loophole through which a few brokers are driving large trucks. One suspects that the CFTC and NFA will become interested soon.

Another area continuing to receive regulatory attention is graciously called a “harmonization issue” by the industry.

Suitability/Know-Your-Customer Requirements This is NFA Compliance Rule 2-30. This basically requires broker-dealers to determine suitability to trade retail FOREX on a customer-by-customer basis, not, as in the old days, with a simple acknowledgment on the account form, “You understand the risk of FOREX trading.” But there is still little specific guidance and enforcement by the NFA. One may expect that to change soon.

Some brokers still allow a customer to deposit and withdraw funds with services such as PayPal and eGold. One strongly suspects Know-Thy-Customer will bring those methods to a close in the not-too-distant future. FOREX brokers now typically do withdrawals in kind: If you made a wire deposit, your withdrawal will be sent by wire.

Margin Requirements In late 2009 the NFA also mandated minimum margin requirements for retail FOREX positions: 1 percent for any pair containing one or both of what the NFA labels as “majors”—USD, GBP, CHF, CAD, JPY, EUR, AUD, NZD, SOK, NOK, DKK. All others now require a 4 percent margin. This means that for U.S. traders the maximum leverage is 100:1 and 25:1, respectively.

Many U.S. broker-dealers have already established overseas offices to stem the tide of customers leaving in droves because of Rule 2-43 and the new margin requirements. Few will want to trade exotic currency pairs at 25:1 leverage.

Foreign Regulation

Many foreign countries also regulate retail FOREX, though typically not at the level of the NFA and CFTC in the United States. The United Kingdom’s Financial Services Authority (FSA) bears the most similarity to the NFA and CFTC.

Regulation Future

Only time will tell if the current pace of regulation will continue, or if it will slow down, allowing participants to digest what they currently have on their plate. But, clearly, the regulatory cat is out of the bag in retail FOREX. Regulation Future bears watching by all players in the retail FOREX space. As we go to press there are rumors that some factions in the CFTC want to force retail FOREX into an exchange environment similar to commodity futures. As mentioned above, the market-making paradigm may be on the chopping block soon. We shall see.

Summary

The FOREX forums are a good place to find updated regulatory information as well as traders’ (and sometimes brokers’) take on them. Both the CFTC web site, (www.cftc.gov) and the NFA web site (www.nfa.futures.org) are worth a peek on a monthly basis. For those who wish to dig deeper, I recommend www.forexlawblog.com. As the Madoff case demonstrates, regulations sometimes miss the forest for the trees; security is truly in your hands and knowledge is still king.

Fraud is always fraud, irrespective of specific industry regulations. I recommend FOREX traders keep copies of everything as well as screenshots of relevant web pages and communication logs.

Regulation Present

Government regulation often is an all-or-nothing effort. For the first 10 years of retail FOREX the CFTC and NFA did little. To be sure, part of the reason was that it took time to get a handle on this loose, freewheeling, and widely disseminated business.

In 2008 and 2009 these agencies poured out new regulations at a ferocious pace—usually without requesting much in the way of feedback from market participants. When I discussed the proposed Compliance Rule 2-43 with an NFA representative at a FOREX trade show in August 2008, I was assured it would be slow in coming and there would be a substantial comment period. Not so. To some extent the economic meltdown of 2008 encouraged this fast-track mode.

The new NFA Compliance Rule 2-43 has wrought havoc on brokers as well as traders. The latest regulations concerning hedging, order placement (First In First Out; FIFO), and money manager registration has sent U.S.-based brokers scurrying to find overseas affiliates that are beyond the reach of the NFA and CFTC. One incentive for brokers: Traders do not like the new regulations either and many are moving their accounts and their money overseas. To that extent, the regulation’s purpose of protecting U.S. citizens who trade FOREX may be partially counterproductive.

In late 2009 brokers found that they had to quickly make major changes to their trading platforms to accommodate the new FIFO and hedging regulations. The sense in the industry was that regulations were made without regard to what was involved in making them work. For example, one of the major independent trading platforms planning to release an updated version in the summer of 2009 was sent “back to the drawing board” at the last minute to implement the necessary code into their software. The situation for most of the summer and fall of 2009 could only be considered as chaotic.

The government often carries a hatchet and meat cleaver when a scalpel and carving knife would have done the job. Nonetheless, those who complain that regulations are typically reactive cannot fault the proactive work of these agencies recently.

TIP: No government, no agency, no regulation can prevent fraud completely. The best protection for traders is knowledge, education, and a firm understanding of what caveat emptor means and implies.

The CFTC Reauthorization Act of 2005

The most critical legislation of interest to U.S. traders is the CFTC Reauthorization Act of 2005; it specifically addresses retail FOREX. The primary thrust of the Reauthorization Act and legislation currently pending is to require retail brokers to meet minimum capital requirements. The new minimum is $20,000,000—up from $5,000,000 just three years ago and no minimum 10 years back. A number of mergers have already taken place. The NFA is also enacting a Know Thy Customer rule for FCMs. This will require them to undertake a more proactive due diligence of prospective clients and their suitability for currency trading. One effect of this will probably be to eliminate account-funding options by PayPal and other electronic transfers except for bank wires.

Traders may wish to periodically check FOREX broker-dealer financials here: www.cftc.gov.

Retail FOREX seems to be following a path parallel to retail futures in the 1970s and 1980s. As predicted in the second edition, Introducing Brokers (IBs) are now required to register and meet minimal capital requirements. I expect mergers between the majors within the next several years as competition, smaller profit margins, and lower growth rates loom.

Similar slow-but-sure regulation of retail FOREX is occurring in other countries. Brokers not domiciled in the United States also should register with the NFA if they desire to prospect and accept accounts from U.S. citizens.

The Financial Markets Association (FMA) has suggested international foreign exchange regulatory standards. FMA’s model code currently has regulatory standing in Australia, Austria, Canada, Cyprus, Hong Kong, Malaysia, Malta, Mauritius, the Philippines, Slovenia, and Switzerland.

Countries with specific agencies regulating FOREX: United Kingdom— Financial Services Authority (FSA); Australia—Australian Securities and Investment Commission (ASIC); Switzerland—requires registration as a Financial Intermediary under Swiss Federal Law; Canada—Investment Canada, Federal Competition Bureau.

Regulation Past of the retail FOREX industry could be considered mild and somewhat tentative. But in early 2008 the NFA and the CFTC began to put some teeth into their regulatory oversight with major new compliance rules.

The Commodity Futures Trading Commission (CFTC)

In 1974 Congress created the Commodity Futures Trading Commission as the independent agency with the mandate to regulate commodity futures and options markets in the United States. The agency is chartered to protect market participants against manipulation, abusive trade practices, and fraud.

Through effective oversight and regulation the CFTC enables the markets to better serve their important function in the nation’s economy, providing a mechanism for price discovery and a means of offsetting price risk. The CFTC also seeks to protect customers by requiring: (1) that registrants disclose market risks and past performance to prospective customers (in the case of money managers and advisors); (2) that customer funds be kept in accounts separate (“segregated funds”) from their own use; and (3) that customer accounts be adjusted to reflect the current market value of their investments at the close of each trading day (“clearing”). Futures accounts are technically safer than securities accounts because brokers must show a zero-zero balance sheet at the end of each trading session.

TIP: The regulatory path of retail FOREX is closely following the path of commodity futures in the 1970s and 1980s—only the pace now has quickened.

National Futures Association

The CFTC was originally created under so-called Sunshine Laws, meaning that its continued existence would be evaluated vis-à-vis its effectiveness. As the futures industry exploded in the late 1970s, not only was its charter renewed but a separate quasi-private self-regulatory agency was created to implement the laws, rules, and regulations. Thus in 1982 was born the National Futures Association (NFA). The NFA is the CFTC’s face to the public and directs the regulatory and registration actions of the CFTC into the marketplace. The NFA stipulates that members cannot transact business with nonmembers. So, for example, if your FOREX broker-dealer is an NFA member, it is not allowed to do business with nonmember money managers (Commodity Trading Advisors or CTAs).

Commodity Futures Modernization Act of 2000

This was the first act by the CFTC pertaining to the then-emerging retail FOREX business. Beginning in the 1980s cross-border capital movements accelerated with the advent of computers, technology, and the Internet— extending market continuum through Asian, European, and American time zones. Transactions in foreign exchange rocketed from about $70 billion a day in the 1980s to more than $2 trillion a day two decades later.

The Patriot Act

A principal feature of the ubiquitous Patriot Act is the desire to limit money laundering so that large transactions might be followed, theoretically ensuring that funds are not headed to finance terrorist activities. It is obvious that such tracking will affect foreign exchange markets. You see reference to the Patriot Act on broker forms when you open an account.

Regulation: Past, Present, and Future

The foreign exchange market has no central clearinghouse as do the stock market and the commodity futures market. Nor is it based in any one country; it is a complex, often freewheeling, loosely woven worldwide network of banks. This network is referred to as the Interbank system. Retail FOREX brokers—in different ways—tap into this network to fill their customers’ orders. These facts permeate every aspect of currency trading, especially the regulatory environment. It is difficult, if not impossible, to get a firm regulatory grip on such an entity. That fact cuts both ways. The market is laissezfaire, but it is also a caveat emptor enterprise. If you wish to trade currencies, you must accept these facts from the beginning.

Regulation in the FOREX Market

In the second edition of Getting Started in Currency Trading, I wrote: The retail FOREX regulatory picture continues to evolve—slowly. Three years ago some broker dealers proudly advertised they were not NFA members. Curiously one of those was REFCO, which failed soon thereafter. Today all of the major broker-dealers have joined the NFA (National Futures Association) and come under the watchful government eye of the CFTC (Commodity Futures Trading Commission). My first advice to you: Do not trade with an unregistered broker-dealer. Every broker-dealer should have his NFA registration number on the web site’s home page.

Regulation is seldom proactive; it usually is the result of a crisis. An NFA spokesman confessed to me that their hands were somewhat tied until a crisis provoked additional legislation. The NFA does host a booth at most FOREX trade shows. If you attend one of these, you might want to ask questions or voice your concerns to the people staffing them. They seem to be good listeners and keep close tabs on the pulse of the FOREX marketplace.

Broker-dealers register as Futures Commission Merchants (FCMs). Currently, Introducing Brokers (IBs) can be covered by the FCM or register independently. As below, it is likely that IBs will all soon be required to register.

Times have changed! In 2008 and 2009 the regulatory agencies in the United States have quickly evolved from a Casper Milquetoast to Magilla Gorilla. The CFTC and NFA have acted quite proactively.

Appendix A, “How the FOREX Game Is Played,” outlines many of the issues for all parties that have prompted the fast-tracking of regulation in retail FOREX.

Regulation Past

In the beginning of retail FOREX, regulations, other than fraud statutes, were essentially non-existent. This was also true of the commodity futures markets up to the mid-1970s. The regulatory path of retail FOREX is following a remarkably similar path to that of commodity futures in the 1970s and 1980s

Contract Specifications

Table 3.1 is a list of currencies traded through IMM at the Chicago Mercantile Exchange and their contract specifications.

Size represents one contract requirement though some brokers offer minicontracts, usually one-tenth the size of the standard contract. Months identify the month of contract delivery. The tick symbols H, M, U, Z are abbreviations for March, June, September, and December, respectively. Hours indicate the local trading hours in Chicago. The minimum fluctuation represents the smallest monetary unit that is registered as one pip in price movement at the exchange and is usually one ten-thousandth of the base currency.
















Currencies Trading Volume

Figure 3.1, FX Futures and Options, summarizes the growth of currency futures trading over five years. Keep in mind that spot trading has also increased in those years.

U.S. Dollar Index

The U.S. Dollar Index (ticker symbol = DX) is an openly traded futures contract
offered by the New York Board of Trade. It is computed using a tradeweighted geometric average of six currencies. See Table 3.2. IMM currency futures traders monitor the U.S. Dollar Index to gauge the dollar’s overall performance in world currency markets. If the Dollar Index is trending lower, then it is likely that a major currency that is a component of the











FIGURE 3.1 FX Futures and Options (Jan 2003–Sep 2008) Source: CME Group, www.cmegroup.com.

Dollar Index is trading higher. When a currency trader takes a quick glance at
the price of the U.S. Dollar Index, it gives the trader a good feel for what is going on in the FOREX market worldwide. For traders who are interested in more details on commodity futures, I recommend Todd Lofton’s paperbound book, Getting Started in Futures (John Wiley & Sons, 2007).















TABLE 3.2 U.S. Dollar Index

Volume and Open Interest

Volume and open interest statistics are not available on the spot market as there is no centralized clearinghouse or exchange to collect the data. It is available for currency futures.

Volume is the total number of transactions over a fixed period of time, usually one trading session. Open Interest is the total number of outstanding futures contracts. If a new long buys from a new short, open interest increases by one. If a new long or new short buys or sells to an old short or old long, open interest does not change. If an old long offsets to an old short, open interest decreases by one. Many technical traders in the futures market consider volume and open interest to be useful forecasting information.

Open Interest is further dissected for analysis in some futures markets between commercial interests (hedgers), large speculators, and small speculators as seen on the web site www.timingcharts.com. A government report issues this information as the Commitment of Traders (COT).

Where to Trade

The primary exchange for futures, FOREX is the International Monetary Market division of the CME Group (www.cmegroup.com). ICE FX (www.theice.com), formerly the New York Board of Trade, makes a market in currency futures.

FOREX Futures

Turnabout is fair play. Some retail spot FOREX brokers now offer trading in silver (XAGUSD) and gold (XAUUSD). TIP: Gold and silver traders with a bent for high risk may find higher leverage available with an overseas retail spot FOREX broker.

Summary

Almost all retail traders prefer spot FOREX. Futures FOREX has its advantages: (1) a centralized exchange, (2) stronger regulation, and (3) availability of daily volume and open interest statistics.

Two Ways to Trade FOREX

Introduction—Futures Contracts

The overwhelming majority of currency trading volume is in the spot market. FOREX inevitably means spot trading to most participants. But it is possible to trade FOREX as a futures vehicle. The primary advantage of FOREX futures lies in the fact that the futures markets are centralized and as such are more heavily regulated. Traders leery of market maker practices in retail spot FOREX may find comfort and a better sleep by trading currencies on a centralized, heavily regulated futures exchange. Indeed, an increase in futures FOREX has been identified in the past two years although volume continues to be dwarfed by the spot market. The selection of traded currency pairs with reasonable liquidity is also smaller in the futures arena. A secondary advantage is that many popular technical trading methods use volume of trading and open interest. While aggregate volume is known in FOREX, daily figures are unobtainable because of the decentralized nature of the business. Attempts are under way, including those by the author, to synthesize spot FOREX volume and open interest statistics from other data using statistical methods. The correlation of spot FOREX data to futures FOREX data has not been promising.

A futures contract is an agreement, or contract, between two parties: a short position, the party who agrees to deliver a commodity, and a long position, the party who agrees to receive a commodity. For example, a grain farmer would be the holder of the short position (agreeing to sell the grain) while the bakery would be the holder of the long (agreeing to buy the grain).

In a futures contract, everything is precisely specified: the quantity and quality of the underlying commodity, the specific price per unit, and the date and method of delivery. The price of a futures contract is represented by the agreed-on price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the grain scenario, the price of the contract might be 5,000 bushels of grain at a price of $4 per bushel and the delivery date may be the third Wednesday in September of the current year.

Options (here meaning delivery months) are staggered throughout the calendar year. Typically the most current option month generates the most trading activity as it is most easily identified with the spot market.

Currency Futures

The FOREX market is essentially a cash or spot market in which more than 90 percent of the trades are liquidated within 48 hours. Currency trades held longer than this are sometimes routed through an authorized commodity futures exchange such as the International Monetary Market (IMM). IMM was founded in 1972 and is a division of the CME Group, formerly the Chicago Mercantile Exchange. CME Group specializes in currency futures, interest-rate futures, and stock index futures, as well as options on futures. Clearinghouses (the futures exchange) and introducing brokers are subject to more stringent regulations from the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and National Futures Association (NFA) agencies than the FOREX spot market (see www.cmegroup.com for more details).

It should also be noted that FOREX traders are charged only a transaction cost per trade, which is simply the difference between the current bid and ask prices. Currency futures traders are charged a round-turn commission varying from broker to broker. In addition, margin requirements for futures contracts are usually slightly higher than the requirements for the FOREX spot market.

Arrival of the Euro

On January 1, 2002, the Euro became the official currency of 12 European nations that agreed to remove their previous currencies from circulation prior to February 28, 2002. See Table 2.1.


















The Euro was considered an immediate success and is now the second most frequently traded currency in FOREX markets behind the USD. Not coincidently the EURUSD is the most traded currency pair.

Since 2002, 10 more countries have adopted the Euro: Andorra, Cyprus, Malta, Monaco, Montenegro, San Marino, Slovakia, Slovenia, Spain, and Vatican City.

The CFTC and the NFA

The new kids on the FOREX block for U.S. traders are the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). Previously dedicated to regulating the commodity futures industry, these agencies are becoming quickly and deeply (many say too deeply) involved in regulating the retail FOREX business. In 2009 NFA Compliance Regulation 2-43 went into effect and has made a significant impact on retail FOREX. Table 2.2 depicts the major events in FOREX history and regulation.

TABLE 2.2 Timeline of Foreign Exchange

1913—U.S. Congress creates the Federal Reserve System.
1933—Congress passes the Securities Act of 1933 to counter the effects of the
Great Crash of 1929.
1934—The Securities Exchange Act of 1934 creates the beginnings of the Securities and Exchange Commission.
1936—The Commodity Exchange Act is enacted in direct response to manipulating grain and futures markets.
1944—The Bretton Woods Accord is established to help stabilize the global economy after World War II.
1971—The Smithsonian Agreement is established to allow for a greater fluctuation
band for currencies.
1972—The European Joint Float is established as the European community tries to move away from their dependency on the U.S. Dollar.
1972—The International Monetary Market is created as a division of the Chicago Mercantile Exchange.
1973—The Smithsonian Agreement and European Joint Float fail, signifying the official switch to a free-floating system.
1974—Congress creates the Commodity Futures Trading Commission to regulate the futures and options markets.
1978—The European Monetary System is introduced to again try to gain independence from the U.S. Dollar.
1978—The free-floating system is officially mandated by the International Monetary Fund.
1993—The European Monetary System fails to make way for a worldwide, freefloating
system.
1994—Online currency trading makes its debut.
2000—Commodity Modernization Act establishes new regulations for securities
derivatives, including currencies in futures or forwards form.
2002—The Euro becomes the official currency of 12 European nations on January 1.
2009—The CFTC and NFA implement NFA Compliance Rule 2-43.
2009—The NFA sets minimum margin requirements for retail FOREX.

Summary

Until the late 1960s the currency markets were extremely stable and very much a closed club. Things were about to change rapidly! Currency trading is probably the world’s second-oldest profession!

The Euro, introduced in 2002, is the official currency of 22 European countries: Andorra, Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Kosovo, Luxembourg, Malta, Monaco, Montenegro, the Netherlands, Portugal, San Marino, Slovakia, Slovenia, Spain, and Vatican City. Lithuania will convert in 2010 and Estonia is expected to convert in 2011. NFA Compliance Rule 2-43 has in many ways changed how the game is played at the retail level.

Some key dates and events—1973, 1978, 1994, 2002, 2009.

The End of Bretton Woods and the Advent of Floating Exchange Rates

After close to three decades of running the international financial system, Bretton Woods finally went the way of history due to growing structural imbalances among the economies, leading to mounting volatility and speculation in a one-year period from June 1972 to June 1973. At the time the United Kingdom, facing deficit problems, initially floated the Sterling. Then it was devaluated further in February of 1973, losing 11 percent of its value along with the Swiss Franc and the Japanese Yen. This eventually led to the European Economic Community floating their currencies as well.

At the core of Bretton Woods’ problems were deteriorating confidence in the dollar’s ability to maintain full convertibility and the unwillingness of surplus countries to revalue for its adverse impact in external trade. Despite a lastditch effort by the Group of Ten finance ministers through the Smithsonian Agreement in December 1971, the international financial system from 1973 onward saw market-driven floating exchange rates taking hold. Several times efforts for reestablishing controlled systems were undertaken with varying levels of success. The most well known of these was Europe’s Exchange Rate Mechanism of the 1990s, which eventually led to the European Monetary Union.

International Monetary Market

In December 1972, the International Monetary Market (IMM) was incorporated as a division of the Chicago Mercantile Exchange (CME) that specialized in currency futures, interest-rate futures, and stock index futures, as well as futures options.

Into the Millennium

Until the arrival of the Euro in 2002 (see next subsection), the international scene has remained essentially unchanged for more than 30 years, although the volume of transactions in foreign exchange has increased enormously. Electronic trading has made it possible to initiate instantaneous trades in the billions of dollars. That has introduced the fragile nature of technology with its lack of redundancy, but no fallout from that has yet to be seen. China’s emergence as a world power has focused attention on its economy and its currency, the yuan, which at the present time is controlled and does not float. The author believes it will be impossible to continue the tight control over the yuan, and floating rates will be inevitable.

Securities and Exchange Commission, 1933–1934

When the stock market crashed in October 1929, countless investors lost their fortunes. Banks also lost great sums of money in the Crash because they had invested heavily in the markets. When people feared their banks might not be able to pay back the money that depositors had in their accounts, a “run” on the banking system caused many bank failures.

With the Crash and ensuing depression, public confidence in the markets plummeted. There was a consensus that for the economy to recover, the public’s faith in the capital markets needed to be restored. Congress held hearings to identify the problems and search for solutions.

Based on the findings in these hearings, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were designed to restore investor confidence in capital markets by providing more structure and government oversight. The main purposes of these laws can be reduced to two commonsense notions:

1. Companies that publicly offer securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.
2. People who sell and trade securities—brokers, dealers, and exchanges must treat investors fairly and honestly, putting investors’ interests first.

The Bretton Woods System, 1944–1973

The post–World War II period saw Great Britain’s economy in ruins, its infrastructure having been bombed. The country’s confidence with its currency was at a low. By contrast, the United States, thanks to its physical isolation, was left relatively unscathed by the war. Its industrial might was ready to be turned to civilian purposes. This then has led to the dollar’s rise to prominence, becoming the reserve currency of choice and staple to the international financial markets.

Bretton Woods came about in July 1944 when 45 countries attended, at the behest of the United States, a conference to formulate a new international postwar period and prevent the recurrence of the 1930s global depression.financial framework. This framework was designed to ensure prosperity in the Named after a resort hotel in New Hampshire, the Bretton Woods system formalized the role of the U.S. dollar as the new global reserve currency, with its value fixed into gold. The United States assumed the responsibility of ensuring convertibility while other currencies were pegged to the dollar. Among the key features of the new framework were:

• Fixed but adjustable exchange rates.
• The International Monetary Fund.
• The World Bank.

A Brief History of Currency Trading

Ancient Times

Foreign exchange dealing can be traced back to the early stages of history, possibly beginning with the introduction of coinage by the ancient Egyptians, and the use of paper notes by the Babylonians. Certainly by biblical times, the Middle East saw a rudimentary international monetary system when the Roman gold coin aureus gained worldwide acceptance followed by the silver denarius, both a common stock among the money changers of the period. In the Bible, Jesus becomes angry at the money changers. I hope His wrath was directed at the poor exchange rates and not the profession itself !

By the Middle Ages, foreign exchange became a function of international banking with the growth in the use of bills of exchange by the merchant princes and international debt papers by the budding European powers in the course of their underwriting the period’s wars.

The Gold Standard, 1816–1933

The gold standard was a fixed commodity standard: participating countries fixed a physical weight of gold for the currency in circulation, making it directly redeemable in the form of the precious metal. In 1816, for instance, the pound sterling was defined as 123.27 grains of gold, which was on its way to becoming the foremost reserve currency and was at the time the principal component of the international capital market. This led to the expression “as good as gold” when applied to Sterling—the Bank of England at the time gained stability and prestige as the premier monetary authority.

Of the major currencies, the U.S. dollar adopted the gold standard late in 1879 and became the standard-bearer, replacing the British pound when Britain and other European countries came off the system with the outbreak of World War I in 1914. Eventually, though, the worsening international depression led even the dollar off the gold standard by 1933; this marked the period of collapse in international trade and financial flows prior to World War II.

The Fed

As an investor, it is essential to acquire a basic knowledge of the Federal Reserve System (the Fed). The Federal Reserve was created by the U.S. Congress in 1913. Before that, the U.S. government lacked any formal organization for studying and implementing monetary policy. Consequently, markets were often unstable and the public had little faith in the banking system. The Fed is an independent entity, but is subject to oversight from Congress. This means that decisions do not have to be ratified by the president or anyone else in the government, but Congress periodically reviews the Fed’s activities.

The Fed is headed by a government agency in Washington known as the Board of Governors of the Federal Reserve. The Board of Governors consists of seven presidential appointees, each of whom serve 14-year terms. All members must be confirmed by the Senate, and they can be reappointed. The board is led by a chairman and a vice chairman, each appointed by the president and approved by the Senate for four-year terms. The current chair is Ben Bernanke, who was sworn in on February 1, 2006, to a 4-year term.

There are 12 regional Federal Reserve Banks located in major cities around the country that operate under the supervision of the Board of Governors. Reserve Banks act as the operating arm of the central bank and do most of the work of the Fed. The banks generate their own income from four main sources:

1. Services provided to banks.
2. Interest earned on government securities.
3. Income from foreign currency held.
4. Interest on loans to depository institutions.

The income generated from these activities is used to finance day-to-day operations, including information gathering and economic research. Any excess income is funneled back into the U.S. Treasury.

The system also includes the Federal Open Market Committee, better known as the FOMC. This is the policy-creating branch of the Federal Reserve. Traditionally the chair of the board is also selected as the chair of the FOMC. The voting members of the FOMC are the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions whether or not they are voting members. The FOMC makes the important decisions on interest rates and other monetary policies. This is the reason they get most of the attention in the media.

The primary responsibility of the Fed is “to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar, and moderate long-term interest rates.”

In other words, the Fed’s job is to foster a sound banking system and a healthy economy. To accomplish its mission the Fed serves as the banker’s bank, the government’s bank, the regulator of financial institutions, and as the nation’s money manager.

The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the Fed Bank then distributes it to financial institutions. It is also the Fed’s responsibility to check bills for wear and tear, taking damaged currency out of circulation.

The Federal Reserve Board (FRB) has regulation and supervision responsibilities over banks. This includes monitoring banks that are members of the system, international banking facilities in the United States, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Fed also helps to ensure that banks act in the public’s interest by helping in the development of federal laws governing consumer credit. Examples are the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and the Truth in Savings Act. In short, the Fed is the police officer for banking activities within the United States and abroad.

The FRB also sets margin requirements for stock investors. This limits the amount of money you can borrow to purchase securities. Currently, the requirement is set at 50 percent, meaning that with $500 you have the opportunity to purchase up to $1,000 worth of securities.

Most people accept the Fed without question. But a growing minority has concluded that the economy would be better off without it. Let the market decide the ratio between spending and savings, they say. The Fed ultimately acts to redistribute wealth by increasing the money supply and “lending” it cheaply to banks, which in turn lend it back to the people who created the wealth in the first place.

What Tools Do I Need to Trade Currencies?

A computer with reliable high-speed connection to the Internet, a small grubstake, and the information in this book are all that are needed to begin trading currencies. You do not even need the grubstake to practice on; a free demo account is offered by all retail FOREX brokers.

What Does It Cost to Trade Currencies?

An online currency trading account (a micro-account) may be opened for as little as $1! Mini-accounts start at $400. Do not laugh—micro- and miniaccounts are a good way to get your feet wet without taking a bath. Unlike futures, where the size of a contract is set by the exchanges, in FOREX you select how much of any particular currency you wish to buy or sell. Thus, a $3,000 grubstake is not unreasonable as long as the trader engages in appropriately sized trades. FOREX mini-accounts also do not suffer the illiquidity of many futures mini-contracts, as everyone essentially feeds from the same interbank currency “pool.”

Market maker brokers take their expenses and profit by marking up the bid-ask spread. ECN brokers charge a flat lot fee to trade. As an example, if you buy and then later sell 100,000 EURUSD and the spread is two pips, you pay a total of four pips or approximately $40. ECN lot fees vary from $15 to $40 for a 100,000 lot. If you trade a larger lot size and/or frequently you will be able to negotiate these costs.

FOREX versus Stocks

Historically, the securities markets have been considered, at least by the majority of the public, as an investment vehicle. In the past 10 years, securities have taken on a more speculative nature. This was perhaps due to the downfall of the overall stock market as many security issues experienced extreme volatility because of the “irrational exuberance” displayed in the marketplace. The implied return associated with an investment was no longer true. Many traders engaged in the day trader rush of the late 1990s only to discover that from a leverage standpoint it took quite a bit of capital to day trade, and the return—while potentially higher than long-term investing—was not exponential, to say the least.

After the onset of the day trader rush, many traders moved into the futures stock index markets where they found they could better leverage their capital and not have their capital tied up when it could be earning interest or making money somewhere else. Like the futures markets, spot currency trading is an excellent vehicle for the pattern day trader that desires to leverage his or her current capital to trade. Spot currency trading provides more options and greater volatility while at the same time stronger trends than are currently available in stock futures indexes. Former securities day traders have an excellent home in the FOREX market.

There are approximately 4,000 stocks listed on the New York Stock Exchange. Another 2,800 are listed on the NASDAQ. Which one will you trade? Trading just the seven major USD currency pairs instead of 6,800 stocks simplifies matters significantly for the FOREX trader. Fewer decisions, fewer headaches. The trader can specialize in one, two, or three currency pairs and have a full plate offering all the opportunity he or she can seize.

FOREX versus Futures

The futures contract is precisely that—a legally binding agreement to deliver or accept delivery of a specified grade and quantity of a given commodity in a distant month. FOREX, however, is a spot (cash) market in which trades rarely exceed two days. Many FOREX brokers allow their investors to rollover open trades after two days. There are FOREX futures or forward contracts, but almost all activity is in the spot market facilitated by rollovers.

In addition to the advantages listed, FOREX trades are almost always executed at the time and price asked by the speculator. There are numerous horror stories about futures traders being locked into an open position even after placing the liquidation order. The high liquidity of the foreign exchange market (roughly three times the trading volume of all the futures markets combined) ensures the prompt execution of all orders (entry, exit, limit, etc.) at the desired price and time.

The caveat here is something called a requote or dealer intervention, which I discuss in a later chapter.

The Commodity Futures Trading Commission (CFTC) authorizes futures exchanges to place daily limits on contracts that significantly hamper the ability to enter and exit the market at a selected price and time. No such limits exist in the FOREX market.

Stock and futures traders are used to thinking in terms of the U.S. Dollar versus something else, such as the price of a stock or the price of wheat. This is like comparing apples to oranges. In currency trading, however, it is always a comparison of one currency to another currency—someone’s apples to someone else’s apples. This paradigm shift can take a little getting used to, but I will give you plenty of examples to help smooth the transition.

The author was a commodity futures trader and registered trading advisor for many years but has found currency trading much more to his liking for many of the reasons listed above.

I must reiterate: There is always some risk in speculation regardless of which financial instruments are traded and where they are traded, regulated or unregulated. Leverage is a door that swings both ways.

Both stock and futures traders must make a similar adjustment to currency trading: In stocks and futures the specific investment vehicle is denominated in dollars or local currency. In FOREX the underlying vehicle is a pair—the relative value of one currency to another.

Summary

FOREX means FOReign EXchange. The FOREX (FX) market is more than a $4 trillion-a-day financial market, dwarfing everything else, including stocks and futures. Because there is no centralized exchange or clearinghouse for currency trading the FOREX market is currently less regulated than other financial markets.

There are a wide variety of reasons to consider FOREX trading, including high leverage and low costs. Access to the FOREX markets via the Internet has resulted in a great deal of interest by small traders previously locked out of this enormous marketplace. Getting started requires only this book, a review of the FX landscape, a computer and Internet connection, and a small grubstake.

Why Trade Foreign Currencies?

In today’s marketplace, the dollar constantly fluctuates against the other currencies of the world. Several factors, such as the decline of global equity markets and declining world interest rates, have forced investors to pursue new opportunities. The global increase in trade and foreign investments has led to many national economies becoming interconnected with one another. This interconnection, and the resulting fluctuations in exchange rates, has created a huge international market: FOREX. For many investors, this has created exciting opportunities and new profit potentials. The FOREX market offers unmatched potential for profitable trading in any market condition or any stage of the business cycle. These factors equate to the following advantages:

• No commissions. No clearing fees, no exchange fees, no government fees, no brokerage fees if you trade with a market maker.
• No middlemen. Spot currency trading does away with the middlemen and allows clients to interact directly with the market maker responsible for the pricing on a particular currency pair, if you trade with an Electronic Communications Network (ECN).
• No fixed lot size. In the futures markets, lot or contract sizes are determined by the exchanges. A standard-sized contract for silver futures is 5,000 ounces. Even a “mini-contract” of silver, 1,000 ounces, represents a value of approximately $17,000. In spot FOREX, you determine the lot size appropriate for your grubstake. This allows traders to effectively participate with accounts of well under $1,000. It also provides a significant money management tool for astute traders.
• Low transaction cost. The retail transaction cost (the bid/ask spread) is typically less than 0.1 percent under normal market conditions. At larger dealers, the spread could be as low as 0.07 percent. Prices are quoted in pips for currencies. Today pip spreads can be zero at some periods for the most actively traded pairs, but typically range from two to five pips.
• High liquidity.With an average trading volume of more than $4 trillion
  per day, FOREX is the most liquid market in the world. It means that
  a trader can enter or exit the market at will in almost any market condition.
  I must note that at the time of the first edition of Getting Started in Currency Trading in 2005, the daily volume was slightly less than $2 trillion.
• Almost instantaneous transactions. This is an advantageous byproduct of
  high liquidity.
• Low margin, high leverage. These factors increase the potential for
  higher profits (and losses) and are discussed later. Traders have access to
  leverage of up to 400 percent although 50 percent to 100 percent is
  most common. 400:1 leverage means $1 controls $400 of currency.
• A 24-hour market. A trader can take advantage of all profitable market conditions at any time. There is no waiting for the opening bell. Markets are closed from Friday afternoon to Sunday afternoon. As the markets transition to the Asian Session, they usually go quiet from 5 P.M. to 7 P.M. Eastern Standard Time.
• Not related to the stock market. Trading in the FOREX market involves selling or buying one currency against another. Thus, there is no hard correlation between the foreign currency market and the stock market although both are measures of economic activity in some way and may be correlated in specific respects for a limited period of time. A bull market or a bear market for a currency is defined in terms of the outlook for its relative value against other currencies. If the outlook is positive, we have a bull market in which a trader profits by buying the currency against other currencies. Conversely, if the outlook is pessimistic, we have a bull market for other currencies and traders take profits by selling the currency against other currencies. In either case, there is always a good market trading opportunity for a trader. Although big price moves occur frequently, a crash is less likely to happen in currencies than stocks because a pair measures relative value. The U.S. Dollar (USD) can be in deep trouble, but so can the European Euro (EUR). The game is the ratio between the two. The top four traded currencies are: the U.S. Dollar (USD), the Euro Dollar (EUR), the Japanese Yen (JPY), and the British Pound (GBP). Fund managers are beginning to show interest in FOREX because of this non-correlation with other investments.
• Interbank market. The backbone of the FOREX market consists of a global network of dealers. They are mainly major commercial banks that communicate and trade with one another and with their clients through electronic networks and by telephone. There are no organized exchanges to serve as a central location to facilitate transactions the way the New York Stock Exchange serves the equity markets. The FOREX market operates in a manner similar to that of the NASDAQ market in the United States; thus it is also referred to as an over-the-counter (OTC) market. The lack of a centralized exchange permeates all aspects of currency trading.
• No one can corner the market. The FOREX market is so vast and has so many participants that no single entity, not even a central bank, can control the market price for an extended period of time. Even interventions by mighty central banks are becoming increasingly ineffectual and short-lived. Thus central banks are becoming less and less inclined to intervene to manipulate market prices. (You may remember the attempt to corner the silver futures market in the late 1970s. Such disruptive excess is not likely in the FOREX markets.)
  
• No insider trading. Because of the FOREX market’s size and noncentralized nature, there is virtually no chance for ill effects caused by insider trading. Fraud possibilities, at least against the system as a whole, are significantly less than in any other financial instruments.
• Limited regulation. There is but limited governmental influence via regulation
  in the FOREX markets, primarily because there is no centralized location or exchange. Of course, this is a sword that can cut both ways, but the author believes—with a hearty caveat emptor—less regulation is, on balance, an advantage.Nevertheless, most countries do have some regulatory say and more seems on the way. Regardless, fraud is always fraud wherever it is found and subject to criminal penalties in all countries. Regulatory bodies such as the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA) are just now beginning to get a handle on some limited control of the retail FOREX business.
  
• Online trading. The capability of trading online was the impetus for retail FOREX. Today you can select from more than 100 online FOREX broker-dealers. Although none is perfect, the trader has a wide variety of options at his or her disposal.
• Third-party products and services. The immense popularity of retail
  FOREX has fostered a burgeoning industry of third-party products and
  services.
  
  

How Are Currency Prices Determined?

Currency prices are affected by a large matrix of constantly changing economic and political conditions, but probably the most important are interest rates, economic conditions, international trade, inflation or deflation, and political stability. Sometimes governments actually participate in the foreign exchange market to influence the value of their currencies. Governments do this by flooding the market with their domestic currency in an attempt to lower the price or, conversely, buying in order to raise the price. This process is known as central bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. Reports of sudden changes in such factors as unemployment can drive currency prices sharply higher or lower for a short period of time. In fact, news traders specialize in attempting to capitalize on such surprises. Technical factors, such as a well-known chart pattern, may also influence currency prices for brief periods. However, the size and volume of the FOREX market make it impossible for any one entity to drive the market for any length of time. Crowd psychology and expectations also figure in the equation determining the price of a currency relative to another currency. There are an enormous number of correlations between all these factors and they are almost certainly nonlinear in nature. That means they are constantly changing and rearranging themselves, sometimes in nonpredictive ways. Now you see it, now you don’t. If you focus on one or a few of them, the others might change unnoticed. Quantum theory comes to mind.

What Is a Spot Market?

A spot market is any market that deals in the current price of a financial instrument. Futures markets, such as the Chicago Board of Trade, offer commodity contracts whose delivery date may span several months into the future. Settlement of FOREX spot transactions usually occurs within two business days. There are also futures and forwards in FOREX, but the overwhelming majority of traders use the spot market. I discuss the opportunities to trade FOREX futures on the International Monetary Market.
















Which Currencies Are Traded?

Any currency backed by an existing nation can be traded at the larger brokers. The trading volume of the major currencies (along with their symbols) is given in descending order: the U.S. Dollar (USD), the Euro Dollar (EUR), the Japanese Yen (JPY), the British Pound Sterling (GBP), the Swiss Franc (CHF), the Canadian Dollar (CAD), and the Australian Dollar (AUD). See Table 1.1. All other currencies are referred to as minors and those from smaller countries, exotics.

FOREX currency symbols are always three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country’s currency. (The “CH” in the Swiss Franc acronym stands for Confederation Helvetica.)

A FOREX transaction is always between two currencies. This often confuses new traders coming from the stock or futures markets where every trade is denominated in dollars. The price of a pair is the ratio between their respective values. Pairs, crosses, majors, minors, and exotics are terms referencing specific combinations of currencies.

Who Trades on the Foreign Exchange?
There are two main groups that trade currencies. A minority percentage of daily volume is from companies and governments that buy or sell products and services in a foreign country and must subsequently convert profits made in foreign currencies into their own domestic currency in the course of doing business. This is primarily hedging activity. The majority now consists of investors trading for profit, or speculation. Speculators range from large banks trading 10,000,000 currency units or more and the home-based operator trading perhaps 10,000 units or less. Retail FOREX, as much as it has grown in the past 10 years, still represents a small percentage of the total daily volume but its numbers and significance are growing rapidly.

Today, importers and exporters, international portfolio managers, multinational corporations, high-frequency traders, speculators, day traders, longterm holders, and hedge funds all use the FOREX market to pay for goods and services, to transact in financial assets, or to reduce the risk of currency movements by hedging their exposure in other markets.

A producer of widgets in the United Kingdom is intrinsically long the British Pound (GBP). If they sign a long-term sales contract with a company in the United States, they may wish to buy some quantity of the USD and sell an equal quantity of the GBP to hedge their margins from a fall in the GBP.

The speculator trades to make a profit by purchasing one currency and simultaneously selling another. The hedger trades to protect his or her margin on an international transaction (for example) from adverse currency fluctuations. The hedger has an intrinsic interest in one side of the market or the other. The speculator does not. Speculation is not a bad word. Speculators add liquidity to a market, making it easier for everyone to transact business by setting efficient prices. They also absorb risks that exist in the marketplace. This latter differs from the gambler who creates risks in order to take them.