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Best Of The Basics

An Introduction to the Fixed Income Market

This article is a basic introduction to the fixed income market.  It covers the primary facets and features of fixed income as they relate to trading from the individual, as opposed to institutional, perspective.

The term “fixed income” is used to describe a collection of securities which have predefined pay-out terms.  An example would be a certificate of deposit (CD) in which one deposits a set amount of money and in return receives a given amount of money, which includes both the original deposit plus interest income, at some future date, known as the maturity.  Fixed income securities, unlike stocks, are based on loans.  While one might think of “buying” a CD, what he/she is in fact doing is loaning the bank money, for which they are paying interest.  That interest, which is predetermined in some fashion at the outset, is the “fixed income”.

Money Markets
Fixed income securities come in a wide array of maturities.  Those with initial maturities of one year or less trade in what is often referred to as the money market.  This term comes from the fact that these short-term instruments tend to be very liquid and often traded between banks.  Money market instruments included such things as:

  • Bankers’ Acceptance: A draft or bill of exchange accepted by a bank to guarantee payment of a bill.
  • Certificate of Deposit: A time deposit with a specific maturity date shown on a certificate; large-denomination certificates of deposits can be sold before maturity.
  • Commercial Paper: An unsecured promissory note with a fixed maturity of one to 270 days; usually it is sold at a discount from face value.
  • Eurocurrency Deposit: Currency deposits in a domestic bank branch or a foreign bank located outside the country of the currency in question.  For example, Eurodollars are deposits of US Dollars outside the United States.
  • Federal Agency Short-Term Securities (in the US): Short-term securities issued by federally sponsored agencies such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
  • Federal Funds (in the US): Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve.  These are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
  • Municipal Notes: Short-term notes issued by municipalities (cities, towns, counties, etc.) in anticipation of tax receipts or other revenues.
  • Repurchase Agreements: Short-term loans – normally for less than two weeks and frequently for one day – arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
  • Treasury Bills: Short-term debt obligations of a national Treasury issued to mature in 3 to 12 months.

Most of the securities above are out of the realm of the individual trader, but a handful can be traded, generally via the futures markets.  Money market instruments normally trade at a discount which means the buyer (lender) pays some amount below the final pay-off value.  For example, if a Treasury Bill is going to pay 100 at maturity, the buyer might pay 95.  The difference would be the interest earned.

Notes and Bonds
The intermediate term fixed income market is made up of securities which are generally (but not exclusively) referred to as notes.  They are instruments which have initial maturities of two to ten years.  Bonds, on the other hand, are the longer-term instruments with initial maturities of more than ten years at the time of issuance.

The standard structure of notes and bonds are the same.  They each feature a par or principle value which is paid at maturity, as well as intermediate interest payments, referred to as coupon payments, which are paid out on a predefined periodic basis (monthly, semi-annually, etc.).  The coupons represent the nominal interest on the bond or note.  For example, if a bond has a 100 par value, and a coupon of 10 per year, that means a 10% interest rate.

Notes and bonds, however, will not always trade at par value. Depending on the overall interest rate market, they can be priced at a discount (below par) or at a premium (above par). The result is that the effective interest rate may not be the same as the nominal rate. For example, if the bond  above were trading at 90, the effective interest rate would be 11.11%. Note, though, that the bond price of 90 represents a 10 point discount off the 100 par value. Those 10 points become extra profit to the bondholder when he/she is paid par at maturity. That then becomes part of the yield to maturity equation. If the bond in the example has a 20-year maturity, its yield to maturity is about 11.28%. Were the bond trading at a premium (above 100), then the yield to maturity would be lower than both the effective and nominal interest rate.

Notes and bonds are both actively traded on a number of exchanges. Individual traders can transact in them via either the cash or futures market.

Callable vs. Non-Callable
Some fixed income instruments are callable. That means the issuer can essentially buy them back from the holders prior to maturity. Normally there are specific terms related to this such as a date after which calling is allowed, or not allowed. When an issue is called, the holder receives the par or principal value, and sometimes a premium as well, depending on the call conditions.

Issuers
Fixed income securities are issued by a wide array of organizations. Probably the best known and most liquid of them all are the government instruments, which are often referred to as sovereign debt because they come from national governments. They come in a wide array of varieties and maturities from country to country, though the most commonly traded securities tend to be the notes and bonds. They have names like Gilts (UK), Bunds (Germany), and JGBs (Japan). Individuals can trade in government debt via the cash market through direct purchase, or they can go through the futures market.

Corporate debt is also quite well common. A great many companies issue debt as an alternative to issuing more stock. Many of these issues, generally notes and bonds, are listed and traded on stock exchanges. As such, they are readily tradable by anyone with a brokerage account.

States, counties, cities and towns also issue debt, which is commonly referred to as municipal or muni debt. These issues are often less well known and actively traded than government or corporate securities. Unlike the other two, however, they often come with incentives for the debt holder such as the interest being federally tax-deductible.  As such, they will generally trade at lower yields.

Government agencies and quasi-government agencies also issues fixed income instruments. Among the best known in the U.S. are the Federal National Mortgage Association (FNMA – Fannie Mae) and the General National Mortgage Association (GNMA – Ginnie Mae). Like government debt, these instruments are accessible to the individual through either the cash or futures market.

The last major group of issuers is the supra-national organizations such as the World Bank.  These issues are not commonly a part of the portfolio of the individual trader, but can be transacted in the cash market.

Credit Ratings
Fixed Income securities all have ratings assigned to them by one or more credit agencies. These ratings are an indication of the creditworthiness of the issuer. They are essentially an indication of how likely the instrument is to be paid off by the terms of its issuance. The higher the rating the better. For example, the sovereign debt of most major industrial countries is of the highest rating. So too are those of many large corporations. An issuer need not have a top level rating for it’s securities to be considered a good risk, though the yields will generally increase with lower debt ratings.

Non-investment grade debt, or junk as it is often called, is the collection of securities which carry low ratings. Issuers with ratings in this category often have high amounts of debt outstanding, may possibly have defaulted, or otherwise are considered to be in financial stress, suggesting that the debt holder is at risk of not being paid off as per the terms.

Influences on Fixed Income Prices
Since the fixed income market is driven by interest rates (prices are inversely related to yields), those things which impact on rates directly influence prices. The biggest driver of these rates, from a macro perspective, is monetary policy, the decisions central banks make in regards to the level of domestic interest rates. Since the central banks directly control interest rates (at least short-term rates), they have a heavy influence over their level and direction.  Other, less direct, influencers include:

  • Government fiscal policy
  • General economic growth
  • Employment
  • Inflation
  • Currency exchange rates and trade

Obviously, when considering the likes of corporate debt, considerations related to that particular issuer come in to play. This includes things like earnings, total debt outstanding, interest cover ratios, and others. All of this, though, is also account for in the credit rating.

Yield Curve
The yield curve is the graphic portrayal of yields over the array of maturities, from shortest to longest. An example is shown on the following chart.

sample yield curve

Notice that the plot above depicts two lines. The blue line is the more standard, upwardly sloping yield curve in which the longer-maturities feature higher yields. The spread between the long maturity issues over the short maturity ones is positive. The pink line, shows an inverted, or negatively sloped curve. A negatively sloped curve is often considered an indication of a pending downturn in the economy as the higher return on short term money will tend to prevent longer-term investment.

It should be noted that while it is most often the case that when one discusses yield curves that it is the government rate curve to which is being referred, it need not always be the case. There are yield curves for corporate debt, for example.

Additional Topics

  • Mortgage-Backed Security (MBS): Instruments which are based on commercial and residential property mortgage loans. These loans are packaged together and securitized by the likes of Fannie Mae. The primary consideration for an MBS is that since mortgages can be prepaid, the actual maturity of the security is unknown, though it can be estimated.
  • Convertible: Some bonds and notes (mostly corporate) can be exchange for another security (generally stock). For example, a company could issue a bond which allows the holder to convert the bond in to 10 shares of company stock. The terms of these conversions are pre-set in terms of price of the security into which the issue can be converted, and oftentimes also the time frame in which the conversion is allowed. The price of convertible securities are heavily influenced by the price of the security they are convertible into.
  • Inflation Protected Securities: This is a group of fixed income securities which are tied in to inflation, as measured by the Consumer Price Index (CPI) or some other similar measure. The interest and/or principal payments of such instruments vary based on a formula. The idea is the nullify the influence of inflation on the holder so that the real rate of return (nominal rate minus inflation) will remain fairly steady.

Further Study

This article is but a brief introduction to fixed income. If you wish to go further, consider the following as worthy resources.

[easyazon-link asin=”0071768467″]The Handbook of Fixed Income Securities[/easyazon-link]

[easyazon-link asin=”B004OC01CM”]Interest Rate Markets - A Practical Approach to Fixed Income[/easyazon-link]

[easyazon-link asin=”0750660783″]Bond and Money Markets - Strategy Trading Analysis[/easyazon-link]

[easyazon-link asin=”0470850639″]Fixed Income Strategy  A Practitioners Guide to Riding the Curve[/easyazon-link]

[easyazon-link asin=”1556232896″]The Bond Market - Trading and Risk Management [/easyazon-link]

 

Categories
The Basics

Economic Data and its Influence on the Financial Markets

The things which contribute to price levels and action in the financial markets are numerous and diverse, and their influences can vary through time, and across different markets. This article identifies the different types of Economic Data influences and the role they play.

There are two ways economic information can influence prices. The first is in the macro sense. Macroeconomic inputs include:

  • Interest Rates
  • Economic Growth (GDP)
  • Government Budget Surpluses/Deficits
  • Trade Balances
  • Commodity Prices
  • Relative Currency Exchanges Rates
  • Inflation
  • Corporate Earnings (both for individual companies and the broad collection)

These elements will generally all have long-term inputs in to the pricing of any given market. They do not tend to move in sharp, dramatic fashion, so their influences also tend to be seen over longer periods of time.

That said, the release of economic data related to the above can be seen to have serious impact in the short-term activity in the markets. This comes primarily in the form of data releases. Some of the most important are:

  • Employment Data
  • Trade Data
  • GDP growth figures
  • Consumer & Producer Inflation rates
  • Retail and Wholesale Sales
  • Confidence & Sentiment Readings (U. Michigan survey, etc.)
  • Income & Spending
  • Production
  • Interest Rate policy decisions
  • Earnings releases

The markets can react in very, very dramatic fashion to these releases when they are out of line with expectations. The foreign exchange market, namely the EUR/USD exchange rate, provides a striking example.

On one Friday morning at 8:30 Eastern the monthly Non-Farm Payrolls report hit the wires. This report (released on the first Friday of each month) probably provides the most short-term volatility across all market sectors of any regular economic release. When the data comes in well off of market expectations, fireworks can ensue, as was the case in the example. Over the course of about 2-3 minutes EUR/USD fell more than 20 pips, turned around and rose about 60 pips, then fell back down to near where it had been before the data was announced (a pip being 1/10,000 of a Dollar). It then proceeded to run nearly 100 pips higher in fairly steady fashion over the course of the next hour.

Here is another example, this time of T-Bond futures.

When those payroll figures were released at 8:30 the market dropped more than two full points. One point on the T-Bond futures contract is worth $1000, so each contract fell more than $2000 in about two minutes. Consider that the margin on a contract at the time was probably around $2500. That means a trader could have lost more than 80% on the trade in the blink of an eye.

It is also important to understand that in the futures pits such data events often result in fast market conditions. This means that the action is so hectic that there may literally be trading going on at several different prices in different parts of the pit. This is a risk of having open positions at the time of a major news release. The market may snap back fairly quickly, as in the chart above, but in the meantime the trader’s positions may have been liquidated on a stop order at a substantial loss.

Fortunately, all major economic releases are well documented. They are done on a pre-announced calendar which is readily available on any number of web sites, and of course in the business news media. In the vast majority of cases, one can also find out ahead of time from any number of sources what the expectations are for the release.

Foreknowledge of pending data events may not prevent losses which may result from unexpected figures. It will, however, allow the trader to recognize and understand when risks are increased. Make sure, especially if you are a short-term trader, to know what data is coming out. It can make a difference in your performance.

Categories
The Basics

Getting Started Trading Forex

Terminology and Market Conventions

If you are going to trade forex you need to understand the terms and quoting conventions used, especially in regards to the spot market.

Notational Conventions
The forex market uses 3-letter codes for all currencies.  These are commonly known as SWIFT or ISO codes.  For example, USD is the code for the US Dollar. Here are the codes for the other primary currencies:

AUD: Australian Dollar
CAD: Canadian Dollar
CHF: Swiss Franc
EUR: European Euro
GBP: British Pound
JPY: Japanese Yen
( For a complete listing of all currency SWIFT codes, click here. )

Expressing a relational value between two currencies is done by combining two currency abbreviations in the fashion of XXX/YYY. This indicates the amount of YYY currency (the “quote” currency) equivalent to one unit of XXX (“base” currency).  For example if the exchange rate for USD/JPY – the US Dollar to Japanese Yen rate – was 100 it would mean that each USD is worth 100 JPY.

Using this convention, changes up or down in the quoted exchange rate indicate changes up or down in the value of the base currency. Using the USD/JPY example again, if the rate went from 100 to 101 it would mean a 1% increase in the value of the USD against the JPY.  Similarly, a decline from 100 to 99 would represent a 1% fall in the USD value vs. the JPY.

In theory, one could quote the exchange rates either way around – meaning if USD/JPY is 100 it is the same as saying JPY/USD is 0.01 (one JPY is worth $0.01). In practice, however, the forex market has specific conventions for the traded pairs.  In most cases, USD is the base currency, with the other currency in question being the quote currency. USD/JPY is an example.

There are a few exceptions, though. When it was introduced in 1999, the market authorities decided the Euro would always be the base currency in all traded pairs. Before that, the Pound (GBP) held that distinction. Thus, when traded against either of those, the USD is the quote currency (EUR/USD, GBP/USD). The same also holds for former British Commonwealth currencies the Australian Dollar (AUD/USD) and the New Zealand Dollar (NZD/USD).

It is worth noting that forex futures contracts involving currencies as quoted against the US Dollar do not hold to the spot market convention.  Instead they all use the USD as the quote currency.

Majors and Crosses
In the forex you will here the terms “majors” and “crosses” when traders refer to different categories of currency pairs.  In general terms, the “majors” are the pairs which include the USD quoted against the other primary industrialized currencies. Those include the ones listed above. So the majors are as follows:

AUD/USD
EUR/USD
GBP/USD
USD/CAD
USD/CHF
USD/JPY

While technically every currency pairing is a cross-rate, the term “cross” is most commonly used to refer to currency pairings which do not include the USD. For example, EUR/JPY is the Euro-Yen exchange rate. That would be considered a cross.

Forex Price Quotes
With an understanding of what we are looking at, now we can turn out focus to the actual price quotes.  The graphic shows a sample table of quotes for an array of currency pairs – majors and crosses.

One thing you will notice in the table is that some pairs are quoted to four decimal places, while others only go out two places.  In general terms, those pairs with values of about 10 or less will go out to four places, while those with higher values will be quoted only at two places.

Regardless of how many decimal places a currency pair is quote to, though, the term “pip” is used to define a single price movement value. So, for a two decimal place pair, a pip would be .01, while for a four decimal place pair a pip would be .0001.

We can see this in the quotes on the chart, especially when looking at the bid/offer spreads.  AUD/JPY is quoted at 79.60-79.64, which is a 4 pip spread, while AUD/USD is quoted 0.7648-0.7650 for a 2 pip spread.

In recent times there has been introduced the “pipette”, which is a fraction of a pip. In essence, some of the more popular pairs like EUR/USD are trading at five decimal places now, which is why you can see a spread of 1.5 listed on the chart (column to the right of the price quote itself).  That means the bid-offer spread is 1 and 5/10 pips.

One will sometimes here the term “figure” in spot forex trading. That is used to refer to a price level which is a round 100 pip figure.  In USD/JPY that would be a multiple of 1 full JPY (such as 104), while in GBP/USD the figure would be a $0.01 multiple (like 1.8800).

The term “yard” sometimes comes up as well.  That is used to refer to a one billion base currency transaction.  So a yard of USD/JPY would be $1 billion.

Getting in to the Trading

Opening an Account
It is quite easy to start trading forex. There are a great many forex brokers available and opening an account is pretty straightforward. Some things you should consider as you look to identify the one best suited to you are:

  • Account minimum deposit (if any)
  • Transaction size flexibility
  • Spreads
  • Execution
  • Commissions (if any)
  • Security of deposited funds
  • Allowable leverage
  • Currency pairs available for trading
  • Usability of the trading platform

The great thing is that nowadays the vast majority of brokers have available demo trading platforms you can use to evaluate their system. Be sure, though, to make note of any differences there are between the real platform and the demo one.  Some brokers’ platforms are both the same across the board, but some have noticeable differences in things like execution speeds. It wouldn’t hurt to check around the discussion boards to see what others are saying.

Actually, if you are new to forex trading it is well worth it to spend a while trading via a demo platform first.  It will help you develop and understanding of how it all works.  That way, when you do go live, you will be more confident and ready for action.

Making Trades
Forex market trading is really little different from an execution perspective than most other markets. You can buy or sell. In most cases, the same types of orders (stops, limits, etc.) are available.  The trading platforms are very modern and trades can be done very quickly.  Anyone who has ever used an online trading platform for any other market will have no trouble making the move to forex and executing trades with ease.  For that matter, even those new to trading will find entering and exiting forex positions a breeze.

Categories
The Basics

Understanding Forex Positions & Profits

Understanding the Trades

The best way to understand what happens in a forex trade is to demonstrate by way of example.  In this case we will outline a trade in which we buy EUR/USD at 1.2100. 

Remember, when buying or selling in the forex market you are doing so in regards to the base currency (the first one listed in the pair).  That means for EUR/USD we are long the Euro, and by extension, short the USD.

This diagram shows the way the transaction runs it’s course:

Simple Spot Forex Trade
Buy 100,000 EUR/USD at 1.2100
Borrow 121,000 USD (100,000 x $1.21)
<Pay USD Overnight Rate>
||
Convert USD to EUR at 1.2100
||
Deposit 100,000 EUR
<Earn EUR Overnight Rate>

When we close out this trade, it is a simple reversal process. The EUR position is converted back in to USD and we pay-off the USD loan we took out.  If the exchange rate increased, then we would have Dollars left over, which would be our profit.  For example, if the rate went to 1.25 we would have $4000 left over after paying back our loan (100,000 x $1.25 = $125,000 – $121,000 = $4000)  If the rate had dropped, we would have a shortfall on our loan repayment, and thus a loss on the trade.

For a trader whose account is denominated in US Dollars, the above example is pretty straightforward.  There is only one exchange happening each way. When one is trading cross-rates, however, things get more complex.

Everything remains essentially the same when we enter the trade. If, for example, we were buying 100,000 EUR/JPY at 131.00 we would borrow 13,100,000 JPY (100,000 x 131), exchange that in to EUR, and deposit it. We would pay interest on the JPY loan and earn it on the EUR deposit, just like we did in the EUR/USD example.

The complexity of a cross trade comes when unwinding the trade. Assume EUR/JPY rises to 132.00, and see how the long position unwind would look:

Cross-Rate Trade
Unwind 100,000 EUR/JPY long
(Entered trade at 131.00)
100,000 EUR
||
Convert EUR back to JPY at 132.00
(100,000 x 132 = 13,200,000 JPY)
||
Repay 13,100,000 JPY
(13,200,000 – 13,100,000 = 100,000 JPY remains)

You will note that there are 100,000 JPY remaining after the original JPY loan is repaid.  That is our profit, but as USD-based traders we need to convert that back in to USD for our accounting purposes.  That happens by exchanging the JPY for USD at the current USD/JPY rate.  If that rate is 107.00, then we have a gain of $934.58 on the trade (100,000/107.00).  Of course, we must also take in to account the interest carry when determining our net profit.

Calculating Profits & Losses

The above outlines of forex trades may seem complicated, but as an individual trader, you don’t see all that stuff. When it comes down to determining your profit or loss (P&L), it’s pretty simple. The essence of determining one’s P&L boils down to starting value and ending value (as set by the market).

Here are the formulas for calculating your profit or loss on a forex trade: 

Non-USD Base (i.e. EUR/USD): 
Long:  (Units x R2) – (Units x R1)  or Units x (R2—R1)
Short:  (Units x R1) – (Units x R2)  or Units x (R1—R2)
Where R1 is the starting rate and R2 is the ending one.

Ex: Buy 100,000 EUR/USD at 1.3000 and sell at 1.3100:
(100,000 x 1.31 = $131,000)—(100,000 x 1.30 = $130,000) = $1000

USD Base (i.e. USD/JPY): 
Long:  ((R2/R1) – 1) x Units
Short:  ((R1/R2)  – 1) x Units

Long Ex: Buy 100,000 USD/JPY at 110.00 and sell at 111.00:
(( 111.00 / 110.00 ) – 1) x $100,000 = $909.09
 
Short Ex: Short 100,000 USD/JPY at 110.00 and cover at 109.00:
(( 110.00 / 109.00 ) – 1) x $100,000 = $917.43

As we know from the EUR/JPY example, cross trades require an additional step.  The same calculation can be used as above (the non-USD base is probably the easiest, though either could be used), but the Profit/Loss figure would then have to be converted using one of the currencies involved to get it back to the account currency as demonstrated earlier.

Remember, forex trades have an interest rate carry based on the interest rate differentials.  This can be either positive or negative. For longer-term trades, this can be a significant influence on the final P&L.

Multiple Open Positions

A common piece of advice offered by experienced forex traders to novices is to focus on one currency pair and stick to that.  There are two reasons.  One is to develop a good understanding of one forex relationship and not spreading things too thin.  The other reason is to avoid some of the issues which can crop up when a trader has positions open in multiple currency pairs.

The first of those issues is creating excessive exposure to one currency.  This is done by going long or short the same currency in different pairs.  For example, I you were to sell EUR/USD and at the same time buy USD/JPY you would have two USD long positions.  In shorting EUR/USD you are going long USD, and obviously in buying USD/JPY you are doing the same thing.  This is a very quick way to put your trading account at serious risk if you are not aware of your total exposure.  If the USD were to suffer a decline you would likely lose on both those positions.

The other issue in holding positions in multiple currency pairs is that you can accidentally create a position completely different than what you intended.  For example, if you were to buy EUR/USD and buy USD/JPY the USD exposure in those trades would at least partially offset each other (you are selling USD in the first trade and buying it in the second), depending on the values of the two trades in question.  What you are left with is a long EUR/JPY position, which has very different trading characteristics than either EUR/USD or USD/JPY.

The combination of the risk factor and the offsets that can happen is why even experienced traders often will only carry one open forex position at a time.  It just keeps things simpler.

Categories
The Basics

What Influences Forex Prices?

Foreign exchange rates are both a market unto themselves and an influence on the fundamental situation of other markets.  They reflect the strength or weakness of an economy and are a factor in it.  This kind of duality can create a truly mind-spinning situation at times.  There are a few things, however, which directly influence forex prices.

Interest Rates

Most people will think first of interest rates when the idea of evaluating one currency against another comes in to play.  They are indeed a major part of the forex market equation.  Interest rates on the one side determine the “yield” of a currency, while on the other side can be viewed as a barometer of the position of a country’s  economy (or of an economic region like the European Union).

To that end, the same sorts of things which impact interest rates also play a part in forex prices.  Inflation, or rather the expectations for inflation, is the single largest influence on interest rates.  But even there it is not a clean scenario. If interest rates are rising because of strong economic growth leading to mild concerns about inflation, that tends to be a positive for a currency.  On the other hand, if rates are rising because signs of inflation are starting to show (or significant inflation already exists), that can be a negative.

Keep in mind that the value of a currency is a reflection of its buying power. Inflation erodes that, so a country seeing high rates of inflation will generally have a weaker currency.  This can easily be seen in the emerging markets where interest rates are often quite high, but the the currencies remain weak because of issues with inflation.

Trade

The forex market exists first and foremost to facilitate trade, and trade is a huge determinant in the value of a currency.  The more a country’s goods are in demand, therefore requiring buyers to convert their currencies in to the exporter’s currency, the stronger it will be.  It is a simple supply and demand equation.  More demand means higher values.

Because of this influence, forex traders keep a keen eye on trade data.  These figures, of course, are historical by the time the market sees them, meaning the trade transactions have already happened and their push or pull on a currency’s value have taken place.  What traders want to know, however, is if money is flowing in to or out of a country.

Capital Flows

Capital flows are a parallel to trade.  Rather than representing the value of goods and services being exchanged, they indicate the investment of capital in to a country.  Investment works the same way as trade.  A country receiving a lot of investment money is similar to a country selling a lot of goods on the trade market. It’s currency is in demand.
What creates capital inflows? Higher relative real interest rates (rates adjusted for inflation) is one thing.  Opportunities for investment profits in a country’s stock market is another.  Capital seeks returns.  It will go where it thinks it is going to get the highest one for a given level of perceived risk.

Capital flows are seen in the balance of payments information released by the government. Traders look at it the same way they do the trade data.  Is money coming in or going out of the economy?

Reserve Currency

You may have heard that the US Dollar is a reserve currency, which means other country’s keep a supply of Dollars on hand as a safety measure against adverse conditions.  This helps provide demand for the Dollar, even when the items noted above would suggest a negative scenario.

A similar situation can be found in the fact that global commodities like oil and gold are denominated in US Dollars.  Anyone buying them must exchange their own currency for Dollars in order to make a purchase, providing an added layer of demand for the US currency.

Comparison

The thing which makes the forex market so complex is the fact that when one is trying to perform the kind of fundamental analysis we have discussed here, it is a multisided equation.  Looking at one country is not enough because a currency is valued and traded against an array of others, all of which have their own sets of considerations.

The comparison for a stock trader would be a spread trade in which one is going to buy one company’s shares and sell those of another related one in a bet that the former outperforms the latter.  Obviously, you would buy the stock of the firm with the better fundamental outlook and sell the one which looks weaker.

This multiple analysis is enjoyable to some, but is probably the biggest factor behind the extreme popularity of technical analysis among forex traders. 

Categories
The Basics

Why Should I Trade Forex?

Advantages of Forex

Trade on Your Schedule
The single biggest advantage the forex market has over other markets is its 24-hour nature. A trader can put on or take off positions literally any time of day or night, regardless of their base of operations. That opens the game up to a great many individuals who might not otherwise have the time available to trade.

Consider, for example, the working person with a 9 to 5 type of job.  Most folks like that cannot be expected to operate effectively as day traders in a market such as stocks.  They just can’t spend the requisite time watching the market during trading hours.  With forex, though, one could theoretically day trade in the evenings after work, or in the mornings beforehand.  The forex market is never really closed (yes, in some cases you can even trade on the weekend!).

No (or low) Transaction Costs
For most traders, the forex market also offers the benefit of no transaction costs.  For the most part, forex brokers do not charge commissions (if they do, they are relatively small). There is, of course, the bid/offer spread, which can be viewed as a transaction cost, but the reality of the situation is that most traders buy at the offer and sell at the bid in whatever other market they trade, so that’s really no different.  Actually, the forex spreads can be quite small in the major currency pairs.

Low (or no) Account Minimums
Forex trading is also open to a wider trading demographic in that there are many opportunities to open smaller accounts than is the case in other markets. In fact, there is at least one broker which has no minimum account size.  What’s more, they also have no minimum trade size.  That sort of flexibility opens the door to essentially anyone who wants to explore forex trading.  This isn’t to say that all brokers are that flexible.  There are, however, a great many which offer so-called mini-contracts.

Multiple Trading Vehicles
Additionally, forex trading can be done in a number of fashions.  Many folks tend to think strictly of the spot market.  While that is certainly the largest of the components, it is not the only one.  The futures market has become a bit more attractive with the expansion of e-mini currency contracts.  There are  futures options as well.  What’s more, an array of other option trading alternatives have been popping up, providing traders even more ways to take positions in the forex market.

Always Moving
One of the biggest attractions to forex trading is that there’s just about always something moving. There are a number of primary currencies involved, each of which is continuously interacting with all the others. Chances are, at any given time, there is movement in at least one of those exchange rates based simply on the sheer volume of trading and the number of global news events providing impetus to action. 

Easily Trade Long or Short
In the stock market there are restrictions imposed on selling short. In forex there is nothing of the sort.  It is just as easy to taking a short position as it is to take a long one.

Disadvantages of Forex

No Exchange
The disadvantage to forex, some would say, is in the lack of an exchange system in forex trading.  Some traders find comfort in knowing that there is a regulated mechanism backing their market participation.  What’s more, the lack of a centralized data point means the spot forex market does not have all the great add-on information stock and futures are used to seeing (volume, for example).

Complex Nature
In terms of market analysis techniques, technical analysis is just as useful in forex trading as in any other market – some might say more so. The thing that gives some traders concern. however, is the complexity of the fundamental side of the forex market. Currency exchange rates are influenced by a wide variety of factors, which can fluctuate over time.

Two-Sides to Every Position
By it’s very nature, there are always two sides to the forex market, because currencies are quoted in terms of their value against each other. That means for any given exchange rate there are two countries (or region’s) to take in to consideration.  Sometimes issues related to one of the countries will dominate, while sometimes the other will.  It can be quite fluid in that regard, which can sometimes lead to quite confusing reactions to news and events.

While these issues may seem like significant barriers to trading forex for some, the fact of the matter is that for most folks they are easily overcome. Just like any market, forex requires some getting used to.  Once you do, though, it provides a wide array of opportunity.

Categories
The Basics

What is the Forex Market and How is it Different?

What is Forex?

The foreign exchange market, often referred to as forex, is the market for the various currencies of the world. It is a market which, at its core, is rooted in global trade.  Goods and services are exchanged 24 hours a day all over the world. Those transactions done across national borders require payments in non-domestic currencies.

For example, a US company purchases widgets from a Mexican company. To do the transaction, one of two things is going to happen. The US firm may, depending on the contract terms, make payment in Mexican Pesos. That would require a conversion of Dollars in to Pesos to make payment. Alternately, the payment could be made in Dollars, in which case the Mexican company would then exchange the Dollars for Pesos on their end. Either way, there is going to be some transaction which takes Dollars and swaps them for Pesos.

That is where the forex market comes in. Transactions like that take place all the time. The market maintains a rate of exchange between the US Dollar and the Mexican Peso (and between and amongst all other world currencies) to facilitate that activity. Consider the amount of global trade which takes place and you can see why the forex market is the biggest in the world, dwarfing all others. Literally trillions of dollars worth of forex transactions take place each and every day.

How is the Forex Market Different?

There are some significant differences between the forex market and others like the stock market.  While it may be the feeling that a good trader should be able to handle any market, the fact of the matter is that some structural differences in forex can require a different trading approach.

Time
For most stock traders, the first difference they will notice between the forex market and equities is time frame. Although the hours of stock trading have been expanding in recent years, the forex market is still the only one which can truly be viewed as 24-hour. There is ready forex trading activity in all time zones during the week, and sometimes even on the weekends as well. Other markets may in fact transact 24-hours, but the volume outside their primary trading day is thin and inconsistent.

No Exchanges
The lack of an exchange is probably the next big thing that sticks out as being different in forex. While it is true that there is exchange-based forex trading in the form of futures, the primary trading takes place over-the-counter via the spot market. There is no NYSE of forex.

On the largest scale, forex transactions are done in what is referred to as the inter-bank market. That literally means banks trading with each other on behalf of their customers. Larger speculators also operate in the inter-bank market where they can execute multimillion dollar trades with ease. Individual traders, who generally trade in much smaller sizes, primarily do so through brokers and dealers.

This is something which can trouble stock traders. There is no central location for price data, and no real volume information is attainable. Since volume is an often reported figure in the stock market, the lack of it in spot forex trading is something which takes a bit of getting used to for those making the switch.

Transaction Processing
Also, the lack of an exchange means a difference in how trading is actually done. In the stock market an order is submitted to a broker who facilitates the trade with another broker/dealer (over-the-counter) or through an exchange. In spot forex much of the trading done by individuals is actually executed directly with their broker/dealer. That means the broker takes the other side of the trade. This is not always the case, but is the most common approach.

Transaction Costs
The lack of an exchange and the direct trade with the broker creates another difference between stock and forex trading. In the stock market brokers will generally charge a commission for each buy and sell transaction you do. In forex, though, most brokers do not charge any commissions. Since they are taking the other side of all the customer trades, they profit by making the spread between the bid and offer prices.

Some traders do not like the structure of the spot forex market. They are not comfortable with their broker being on the other side of their trades as they feel it presents a type of conflict of interest. They also question the safety of their funds and the lack of overall regulation. There are some worthwhile concerns, certainly, but the fact of the matter is that the majority of forex brokers are very reliable and ethical. Those that are not don’t stay in business very long.

Margin Trading
The forex market is a 100% margin-based market. This is a familiar thing for those used to trading futures.

In fact, spot forex trading is essentially trading a 2-day forward (futures) contract. You do not take actual possession of any currency, but rather have a theoretical agreement to do so in the future. That puts you in a position of benefiting from prices changes. For that your broker requires a deposit on your trades to provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will asked for as little as 1/2%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.

Now, unlike the stock market, margin trading does not mean margin loans. Your broker will not be lending you money to buy securities (at least not the way a stock broker does). As such, there is no margin interest charged. In fact, since you are the one putting money on deposit with your broker, you may earn interest in your margin funds.

Interest Rate Carry (Rollover)
When trading forex, one is essentially borrowing one currency, converting it in to another, and depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held. This means the trader is either paying out or receiving interest on their position, depending on whether the interest rate differential is for or against them.

This is commonly handled is what is referred to as a rollover. Spot forex trades are done on a trading day basis, and as such are technically closed out at the end of each day. If you are holding your position longer than that, your broker rolls you forward in to a new position for the next trading day. This is generally done transparently, but it does mean that at the end of each day you will either pay or receive the interest differential on your position.

The type of trader you are and the way your broker handles rollover will be the deciding factors in determining whether the interest rate differentials are an important concern for you. Some brokers will not apply the day’s interest differential value on positions closed out during the trading day. By that I mean if you were to enter a position at 10am and exit at 2pm, no interest would come in to play. If you were to open a position on Monday and close it on Tuesday, though, you would have the interest for Monday applied (the full day regardless of when you entered the position), but nothing for Tuesday. (Note: There is at least one broker who calculates interest on a continuous basis, so you will always make or pay the interest differential on all positions, no matter when you put them on or took them off).

It should also be noted that although some folks will claim there is no rollover in forex futures, the interest rate spread is definitely factored in. You can see this when comparing the futures prices with the spot market rates. As the futures contracts approach their delivery date their prices will converge with the spot rate so that the holders will pay or receive the differential just as if they had been in a spot position.

Intervention
Fixed income traders know that central bankers, like the Federal Reserve, are active in the markets, buying and selling securities to influence prices, and thereby interest rates. This is not something which happens in stocks, but it does in the forex markets. This is known as intervention. It happens when a central bank or other national monetary authority buys or sells currency in the market with the objective of influencing exchange rates.

Intervention is most often seen at times when exchange rates get a bit out of hand, either falling or rising too rapidly.  At those times, central banks may step in to try to nullify the trend. Sometimes it works. Sometimes not.

The US has traditionally taken a hands-off approach when it comes to the value of the Dollar, preferring to allow the markets to do their thing.  Others are not quite so willing to let speculators determine their currency’s value. The Bank of Japan has the most active track record in that regard.