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.”
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.”
