Wednesday, April 29, 2015

Market Mechanics


So now we know that the FX market is the largest in the world. Your broker or the institution that you are trading with is collecting quotes from a centralized feed and/or individual quotes comprising of interbank rates.
So how are these quotes made up? Well, as we previously mentioned, currencies are traded in pairs and are each assigned a symbol. For the Japanese Yen it is JPY, for the Pounds Sterling it is GBP, for Euro it is EUR and for the Swiss Frank it is CHF. So, EUR/USD would be the Euro-Dollar pair. GBP/USD would be the Pounds Sterling-Dollar pair and USD/CHF would be the Dollar-Swiss Franc pair and so on.
You will always see the USD quoted first aside for a few exceptions such as Pounds Sterling, Euro Dollar, Australia Dollar and New Zealand Dollar. The first currency quoted is called the base currency. Have a look below for some examples.
Currency Symbol
Currency Pair
EUR/USD
Euro / US Dollar
GBP/USD
Pounds Sterling/ US Dollar
USD/JPY
US Dollar / Japanese Yen
USD/CHF
US Dollar / Swiss Franc
USD/CAD
US Dollar / Canadian Dollar
AUD/USD
Australian Dollar / US Dollar
NZD/USD
New Zealand Dollar / US Dollar
When you see FX quotes you will actually see two numbers. The first number is called the bid and the second number is called the offer (sometimes called the ASK).
If we use the EUR/USD as an example you might see 0.9950/0.9955. The first number 0.9950 is the bid price and is the price traders are prepared to buy Euros against the USD Dollar. The second number 0.9955 is the offer price and is the price traders are prepared to sell the Euro against the US Dollar.
These quotes are sometimes abbreviated to the last two digits of the currency e.g.: 50/55. Each broker has their own convention and some will quote the full number and others will show only the last two.
You will also notice that there is a difference between the bid and the offer price which is called the spread. For the four major currencies the spread is normally 5, give or take a pip (I’ll explain pips later)
To carry on from the symbol conventions and using our previous EUR quote of 0.9950 bid, this means that 1 Euro = 0.9950 US Dollars. For another example, if we used the USD/CAD 1.4500, that would mean that 1 US Dollar = 1.4500 Canadian Dollars.
The most common increment of currencies is the PIP. If the
EUR/USD moves from 0.9550 to 0.9551 that is one pip. A pip is the last decimal place of a quotation. The pip or POINT as it is sometimes referred to, depending on context, is how we will measure our profit or loss.
As each currency has its own value, it is necessary to calculate the value of a pip for that particular currency. We also want a constant, so we will assume that we want to convert everything to US Dollars. In currencies where the US Dollar is quoted first the calculation would be as follows.
Example: the JPY rate of 116.73 (notice the JPY only goes to two decimal places, most of the other currencies have four decimal places)
In the case of the JPY 1 pip would be .01 therefore
USD/JPY:
(.01 divided by exchange rate = pip value) so .01/116.73=0.0000856. It looks like a big number but later we will discuss lot (contract) size later.
USD/CHF:
(.0001 divided by exchange rate = pip value) so .0001/1.4840 = 0.0000673
USD/CAD:
(.0001 divided by exchange rate = pip value) so .0001/1.5223 = 0.0001522
In the case where the US Dollar is not quoted first and we want to get to the US Dollar value we have to add one more step.
EUR/USD:
(0.0001 divided by exchange rate = pip value) so .0001/0.9887 = EUR 0.0001011 but we want to get back to US Dollars so we add another little calculation which is EUR X Exchange rate so
0.0001011 X 0.9887 = 0.0000999 when rounded up it would be 0.0001.
GBP/USD:
(0.0001 divided by exchange rate = pip value) so 0.0001/1.5506 = GBP 0.0000644 but we want to get back to US Dollars so we add another little calculation which is GBP X Exchange rate so
0.0000644 X 1.5506 = 0.0000998 when rounded up it would be 0.0001.
By this time you might be rolling your eyes back and thinking ‘do I really need to work all this out?’, and the answer is no.
Nearly all the brokers you will deal with will work all this out for you. They may have slightly different conventions, but it’s all done automatically. It’s good however for you to know how they work it out. In the next section we will be discussing how these seemingly insignificant amounts can add up.
Spot Forex is traditionally traded in lots, also referred to as contracts. The standard size for a lot is $100,000. In the last few years a mini lot size has been introduced of $10,000 and this again may change in the years to come.
As we mentioned on the previous page, currencies are measured in pips, which is the smallest increment of that currency. To take advantage of these tiny increments it is desirable to trade large amounts of a particular currency in order to see any significant profit. We shall cover leverage later, but for the time being let's assume that we will be using $100,000 lot size. We will now recalculate some examples to see how it affects the pip value.
USD/JPY at an exchange rate of 116.73
(.01/116.73) X $100,000 = $8.56 per pip
USD/CHF at an exchange rate of 1.4840
(0.0001/1.4840) X $100,000 = $6.73 per pip
In cases where the US Dollar is not quoted first the formula is slightly different.
EUR/USD at an exchange rate of 0.9887
(0.0001/ 0.9887) X EUR 100,000 = EUR 10.11 to get back to US Dollars we add a further step
EUR 10.11 X Exchange rate which looks like EUR 10.11 X 0.9887 = $9.9957 rounded up will be $10 per pip.
GBP/USD at an exchange rate of 1.5506
(0.0001/1.5506) X GBP 100,000 = GBP 6.44 to get back to US Dollars we add a further step
GBP 6.44 X Exchange rate which looks like GBP 6.44 X 1.5506 = $9.9858864 rounded up will be $10 per pip.
As we said earlier your broker might have a different convention for calculating pip value relative to lot size, but however they do it they will be able to tell you what the pip value for the currency you are trading is at that particular time. Remember that as the market moves so will the pip value depending on what currency you trade.
So now that we know how to calculate pip value lets have a look at how you work out your profit or loss. Let's assume you want to buy US Dollars and Sell Japanese Yen. The rate you are quoted is 116.70/116.75 and because you are buying the US Dollar you will be working on the 116.75, which is the rate at which traders are prepared to sell.
So you buy 1 lot of $100,000 at 116.75. A few hours later the price moves to 116.95 and you decide to close your trade. You ask for a new quote and are quoted 116.95/117.00. As you are now closing your trade and you initially bought to enter the trade, you now sell in order to close the trade and you take 116.95 which is the price traders are prepared to buy at. The difference between 116.75 and
116.95 is .20 or 20 pips. Using our formula from before, we now have (.01/116.95) X $100,000 = $8.55 per pip X 20 pips =$171
In the case of the EUR/USD you decide to sell the EUR and are quoted 0.9885/0.9890, you take 0.9885. Now don't get confused here. Remember you are now selling and you need a buyer. The buyer is biding 0.9885 and that is what you take. A few hours later the EUR moves to 0.9805 and you ask for a quote.
You are quoted 0.9805/0.9810 and you take 0.9810. You originally sold EUR to open the trade and now to close the trade you must buy back your position. In order to buy back your position you take the price traders are prepared to sell at which is 0.9810.
The difference between 0.9810 and 0.9885 is 0.0075 or 75 pips. Using the formula from before, we now have (.0001/0.9810) X EUR 100,000 = EUR10.19: EUR 10.19 X Exchange rate 0.9810 =$9.99($10) so 75 X $10 = $750.
To reiterate what has gone before, when you enter or exit a trade at some point you are subject to the spread in the bid/offer quote. As a rule of thumb, when you buy a currency you will use the offer price and when you sell you will use the bid price.
So when you buy a currency you pay the spread as you enter the trade but not as you exit and when you sell a currency you pay no spread when you enter but only when you exit.















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