Tuesday, 2 November 2010

Glossary of Terms

American-style option – An option contract that may be exercised at any time before it expires.

Ask – The quoted price at which a customer can buy a currency pair.  Also referred to as the ‘offer,’ ‘ask price,’ or ‘ask rate.’

Base Currency – For foreign exchange trading, currencies are quoted in terms of a currency pair. The first currency in the pair is the base currency. For example, in a USD/JPY currency pair, the US dollar is the base currency. Also may be referred to as the primary currency.

Bid – The quoted price where a customer can sell a currency pair. Also known as the 'bid price' or 'bid rate.'

Bid/Ask Spread – The point difference between the bid and ask (offer) price.

Currency pair – The two currencies that make up a foreign exchange rate. For example, USD/YEN is a currency pair.

Dealer – A firm in the business of acting as a counterparty to foreign currency transactions.

European-style option – An option contract that can be exercised only on or near its expiration date.

Expiration – This is the last day on which an option may either be exercised or offset.

Interbank market – A loose network of currency transactions negotiated between financial institutions and other large companies.

Leverage – The ability to control large dollar amount of a commodity with a comparatively small amount of capital.  Also known as ‘gearing.’

Margin – See Security Deposit.

Offer – See Ask.

Open position – Any transaction that has not been closed out by a corresponding opposite transaction.

Quote currency – The second currency in a currency pair is referred to as the quote currency. For example, in a USD/JPY currency pair, the Japanese yen is the quote currency. Also referred to as the secondary currency or the counter currency.

Rollover – The process of extending the settlement date on an open position by rolling it over to the next settlement date.

Security deposit – The amount of money needed to open or maintain a position. Also known as ‘margin.’

Settlement – The actual delivery of currencies made on the maturity date of a trade.

Spread – The point difference between the ask and bid price of a currency pair.

Trader – An individual who is on the other side of the trade with the dealer and whose objective is to profit from price movements.

The risks of forex trading

Forex trading carries a high level of risk. Take a minute to go through some of those risks.

·         The market could move against you. Fluctuations in the foreign exchange rate between the time you place a trade and the time you close it out will affect the price of your forex contract and the potential profit and losses relating to it.

·         You could lose your entire investment. As mentioned earlier, leverage allows you to hold a large forex position with a relatively small amount of money. If the price moves in an unfavourable direction, high leverage can produce large losses in relation to your initial deposit. In fact, even a small move against your position may result in a large loss, including the loss of your entire deposit. Depending on your agreement with your dealer, you may also be required to pay additional losses.

·         Retail off-exchange forex trades are not guaranteed by a clearing organization. Furthermore, funds that you have deposited to trade forex contracts are not insured and may not receive a priority in bankruptcy. Even customer funds deposited by a dealer in an FDIC-insured bank account may not be protected if the dealer goes bankrupt. Be wary of firms that say “Your investment is protected” or “Your funds are segregated.”

·         Unlike regulated futures exchanges, in the retail off-exchange forex market there is no central marketplace. The forex dealer determines the execution price, so you are relying on the dealer to give you a fair price.

·         If you are using an Internet-based or other electronic system to place trades, some part of the system could fail. In the event of a system failure, it is possible that, for a certain time period, you may not be able to enter new orders, execute existing orders, or modify or cancel orders that were previously entered. A system failure may also result in loss of orders or order priority.

·         As with any investment, you should protect yourself against fraud. Over the last few years, there has been a sharp rise in foreign currency scams, and you should do as much due diligence as you can before trading forex.
        
·         Here are some tips to help you avoid becoming a victim of a forex scam.

·         Stay away from opportunities that sound too good to be true. In general, get-rich-quick schemes tend to be frauds. For example, avoid any forex company that predicts or guarantees large profits. If a company says that they will double or triple your money in one month or will guarantee a monthly return, walk away.

·         Stay away from forex companies that promise little or no financial risk. There is no doubt that trading forex is risky, so if someone is telling you the opposite, they are not being truthful. Beware of forex companies that make the following types of statements: “Whichever way the market moves, you can’t lose” or “While there is risk, it is substantially outweighed by the reward.”

·         Check the background of everyone you will be dealing with. If you cannot satisfy yourself that the persons are completely legitimate and above-board, the wisest course of action is to avoid trading through those companies.

A good place to start checking the background of a forex firm or individual is NFA’s Background Affiliation Status Information Center, or BASIC. It’s available through NFA’s Web site and contains the registration and disciplinary records for individuals and companies involved in the futures industry. Although some forex companies and brokers are not required to be registered with NFA, BASIC ( http://www.nfa.futures.org/ ) is a good place to start to determine if a broker or company has any past industry experience.

If you suspect any wrongdoing or improper business conduct in your forex account, you may contact or file a complaint with NFA by telephone at 800-621-3750 or online at www.nfa.futures.org.

How does LEVERAGE impact Forex Trading?

Off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.

Let’s proceed on the assumption that you have risk capital you would like to use in trading forex. The next question is how much you need to open an account. Forex dealers can set their own minimum account sizes, so you will have to ask the dealer how much money you must put up to begin trading.

Most dealers will also require you to have a certain amount of money in your account for each transaction. This security deposit, sometimes called margin, is a percentage of the transaction value and may be different for different currencies. Keep in mind that a security deposit acts as a performance bond and is not a down payment or partial payment for the transaction.

Let’s use an example of a dealer requiring a 1% security deposit. The formula for calculating the security deposit is:

The current price of the base currency X transaction size X security deposit % = security deposit requirement given in quote currency

Looking at the Euro example we used earlier, multiply the current price of the base currency ($1.4050) times the transaction size of 100,000 times 1%. Your security deposit would be $1,405.00.

$1.4050 X 100,000 X .01 = $1,405.00

Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In the previous example, $1,405.00 would control $140,500 worth of Euros.

This ability to control a large amount of one currency using a very small percentage of its value is called leverage. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.

Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,405.00 on the euro transaction is 1% of the full price but is 100% of the 1% security deposit.

The higher the leverage, the more likely you are to lose your entire investment if exchange rates go down when you expect them to go up or go up when you expect them to go down. Leverage of 100:1 means that you will lose your security deposit when the currency loses or gains 1% of its value, and you will lose more than your security deposit if the currency loses or gains more than 1% of its value. If you want to keep the position open, you may have to deposit additional funds to maintain a 1% security deposit.

For example, assume you buy or sell a contract worth $100,000 and it moves against you by $2,000. No matter how much money you put up, your dollar loss will always be the same—$2,000—but the percentage loss varies with the amount of leverage. At 100:4 leverage, you will have lost half of your investment. At 100:2 leverage, you will have lost your entire investment. And at 100:1 leverage, you will have lost twice your investment and owe the dealer $1,000.

Notional value = $100,000        Loss = $2,000                                       
           
Original Investment             Leverage       Remaining Funds   Loss
$4,000                                    100:4              $2,000                        50%
$2,000                                    100:2              $0                               100%
$1,000                                    100:1              -$1,000                      

You should check your Account Agreement with the dealer to see if the Agreement limits your losses. Some dealers guarantee that you will not lose more than you invest, which includes both the initial deposit and any subsequent deposits to keep the position open. Other dealers may charge you for losses that are greater than your investment.200%

Your Account Agreement with your dealer is crucial. Just as you wouldn’t consider buying a house or a car without carefully reading and understanding the terms of the sale, neither should you establish a forex account without first reading and understanding the Account Agreement and all other documents supplied by your dealer. You should know your rights and responsibilities, as well as the firm’s obligations before you enter into any forex transaction.

In the case of a $100,000 position with 100:1 leverage, the customer would have been required to post a security deposit equal to 1% of the position value. In this case, the security deposit would have been $1,000 ($100,000 X .01). A 1,000 US dollar decline in the value of the position would have completely wiped out the security deposit.

How are foreign currencies quoted and priced?

Currencies are designated by three-letter symbols. The standard symbols for some of the most commonly traded currencies are:



EUR - Euro
USD - United States Dollar
CAD - Canadian Dollar
GBP - British Pound
JPY - Japanese Yen
AUD - Australian Dollar
CHF - Swiss Franc
NZD - Newzealand Dollar

Currency pairs are often quoted as bid-ask spreads. The first part of the quote is the amount of the quote currency you will receive in exchange for one unit of the base currency (the bid price). The second part of the quote is the amount of the quote currency you must spend for one unit of the base currency (the ask or offer price). For example, a EUR/USD spread of 1.4050/1.4055 means that you can sell one Euro for $1.4050 and buy one Euro for $1.4055. This spread could also be quoted as 1.4050/55.
At first glance, the bid and ask prices may seem backwards to you. That is because they are listed from the dealer’s point of view, not from your point of view. The first part of the spread, or the bid, is what the dealer is willing to pay to buy the base currency. So this is the price you will get if you SELL the base currency. In the same way, the second part of the spread, or the ask, is what the dealer is willing to sell the base currency at, so this is the price you will get if you BUY the base currency.

Example:

If the USD/CHF spread is listed as 0.9975/0.9980, you can sell one US dollar for 0.9975 Swiss francs and buy one US dollar for 0.9980 Swiss francs.

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Exercise . 1:

In this currency pair, which is the base currency?
AUD/USD
The answer is the Australian Dollar, or AUD. Remember, the first currency in a currency pair is the base currency and the second currency is the quote currency.

Exercise . 2:

Using this USD/JPY spread (114.45/114.55), how many Japanese yen would it take to buy one US dollar?

It would take 114.55 yen to purchase one US dollar.
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Who determines the execution price—the trader, the dealer or the exchange?

It is the dealer. Remember that the forex markets we are discussing have no central exchange on which the contracts are traded, and you as the trader have no control over the execution price.