Well, these little babies are certainly making a fashion statement in the trading world! Want to learn more about them? Keep reading to hear how these tools can kick-start your trading returns.
Some FX history facts to impress your friends with
FX trading, as we know it today, is a relatively new idea. The first steps towards creating the conditions necessary for retail FX trading came with the Bretton Woods agreement of 1944. Towards the end of the Second World War this agreement laid down the framework for a new-world economic regime. In this regime the US dollar (USD) would be the only currency whose value was convertible at a fixed rate into gold. All other currencies would be quoted in USD terms and would therefore have a surrogate reference to the price of gold.
This system lasted only 27 years as the increasing financial burden of the Vietnam War saw the convertibility of the USD into gold abolished by Richard Nixon. Because of the cost of the Vietnam War, the US could no longer defend a fixed currency. However the Bretton Woods agreement has left a lasting impact as the major currencies to this day are quoted against the USD. It is with the abolition of this agreement that the foundations are laid for FX trading.
In 1976 the International Monetary Fund (IMF) agreed that major currencies should float, so instead of having a fixed value currencies were now free to float against one another. The relative value of these relationships is a reflection of perceptions regarding the strength of each domestic economy.
In 1983 the Hawke government decided to float the Australian dollar (AUD). This flotation has been somewhat mixed in its impact upon the currency. As can be seen from the following two charts the move towards free float caused a 30% devaluation against the USD (Figure One) whereas the drop against the Yen (Figure Two) has been nothing short of precipitous.
Your FX Trainer Wheels
Dealing in FX is somewhat different to dealing in shares or indices. Firstly there is no physical location or major exchange where currency trading takes place. Trading takes place courtesy of a vast network of large banks and dealers who deal directly with one another with no need to deal via either an exchange or use brokers. In addition to this there is a second tier of market participants who offer FX trading to retail clients. Such retail operations are often offshoots of large banks and trading institutions.
Secondly all FX contracts are traded in pairs such as $A/$US or $US/•, this means is that when you go long one currency you are automatically going short its counterpart. For example if I thought that the $A was going to strengthen against the $US I would buy the $A/$US pair. So my instruction would be to buy x number of contracts of the $A/$US pair; or the Aussie as it is sometimes referred to.
Conversely if I thought the $A was going to weaken against the $US, my instruction would be to sell x contracts of $A/$US. It is impossible to trade currencies without reference to another currency. The first currency in the pair is referred to as the base currency and is the currency you are either buying or selling. The second is known as the counter or quote currency. So in this example the $A is the base currency and the $US is the counter or quote currency. So a quote for this pair of 0.7100 means that one $A is worth $US 0.71.
It is extremely important to make certain you understand the quoting conventions of FX trading before you place an order. A failure to understand how quotes are structured could lead you to either buy or sell the wrong currency. And in the financial world there is no sympathy for such mistakes.
The following are a few examples of major pairs and the differing impact of buy and sell orders.
BUY if the $US in a bear market and the Euro is going to go up against the $US. SELL if you expect the $US to recover from its bear market to climb against the Euro.
BUY if you expect the • to weaken. SELL if you expect the • to rise.
BUY if you expect the Swiss franc to slip in value. SELL if your expectations are for a drop in the value of the Euro.
FX is a highly leveraged tool with traders regularly dealing with leverage of up to 100:1 as such it is necessary for traders to understand precisely how much a change in a given currency is worth to them.
Assume that we have bought a single standard contract of $A/$US at 0.7002.
If the quote moves to 0.7003 we make $US 10
If the quote moves to 0.7012 we make $US 100
If the quote moves to 0.7102 we make $US 1000
If the quote moves to 0.8002 we make $US 10000
To get a sense of these changing values we can work out the value of a single contract.
One contract at 0.7003 is worth $US 70,030 ($A100,000 x 0.7003)
One contract at 0.7012 is worth $US 70,120 ($A100,000 x 0.7012)
One contract at 0.7102 is worth $US 71,020 ($A100,000 x 0.7102)
One contract at 0.8002 is worth $US 80,020 ($A100,000 x 0.8002)
Putting this into the context of a trade we get a feeling for the profitability or otherwise of a given strategy.
FX trade example
In this example the $A/$US was bought at 0.6396 and later sold at 0.6800, this yielded a profit of 404 pips or $US 4,040. We can calculate the net result of this trade long hand as in the earlier exploration of quoting conventions.
Bought $A 100,000 @ 0.6396 = $US 63,960
Sold $A 100,000 @ 0.6800 = $US 68,000
The profit for this trade is $US 68,000 – $US 63,960 = $US 4,040. If you are ever in doubt about the value of a trade and your potential exposure it is always worthwhile working through the trade long hand. A few extra lines on a piece of paper and a bit of calculator punching may save you from considerable heartache later on.
Why trade FX?
FX is one of the few ways with which a trader can achieve true diversification – many brokers believe that if your shares have different names then you have a diversified portfolio. In a small closed equity market such as that in Australia diversification is very difficult to achieve – the narrow the index group you trade the higher the correlation you positions will share. FX and also commodities allow traders to have true diversification because equity markets and currency markets are dislocated. So if you encounter a situation where equities are sluggish and not trending you always have an alternative market to look at.
The next step
Turn to experienced traders who have the knowledge, experience and cutting edge techniques to help drive your account into profit. Chris Tate and Louise Bedford are among the best in the business. Have been for decades.
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