Currency Trading (FX): An insights into Fundamentals of Forex Trading

The foreign exchange market; also known as FX, or Forex, is a world-wide, decentralized, over-the-counter financial market that facilitates the trading of currencies between banks, speculators, and investors. Simply put, there is no exchange floor, or even an exchange; instead buyers and sellers are making electronic contractual agreements in regards to underlying currencies. Because there is no exchange, there is also no clearing, or exchange guarantee, and traders are exposed to counter-party risk; this is in contrast to the futures markets, in which an exchange guarantees all executed trades.

The global FX market was created to simplify the transfer of assets between businesses and countries worldwide but in recent years has quickly become a hotbed of speculation. Whether the additional  liquidity brought by speculators has been positive is up for debate, but in the end, it is the Forex market that determines the relative values of various currencies in relation to others.

Below listed are the fundamentals of FX trading:

• In FX, a currency pair is composed of two elements known as a base currency and a quote currency. The base currency is listed first and the quote currency second, with a hyphen or backslash separating the two.
• Some refer to the base currency as the “primary currency” and the quote currency as the “secondary currency.”
• FX currency pairs are most often traded in 100,000 or 10,000 units of the base currency, but some firms offer increments of 1,000. Because size is relatively standard, the FX community often refers to the various contract sizes as a full-sized contract (standard lot), a mini contract, and a micro contract, respectively.
• All currencies must be traded in pairs; in essence, traders are buying one currency and selling the other. Therefore, if you buy the base currency, you are simultaneously selling the quote currency.
• The bid is the price at which a trader can sell, and ask is the price at which a trader can buy. There will always be a spread between these prices, known as the bid/ask spread, or pip spread.

FX Margin and Notional Value of FX Trade

The concept of notional value and margin in FX is similar to the value of a home relative to a down payment. The notional value of the property is the total worth of the home and the fluctuation in this value determines the profit and loss to the buyer. Yet, the home-buyer is only required to put a deposit of 20% down to acquire the property, which is far less than the notional value of the asset.

• In FOREX, a leverage ratio of 50 to 1 means that you can buy or sell $100,000 worth of currency while maintaining a margin balance of just $2,000 in your account.
• As if this weren't confusing enough, because two currencies are involved in each pair, there are potentially two relative notional values (one in each currency). Luckily, it is standard to use the base currency to determine the notional value. To illustrate, if a trader buys 10,000 EUR/USD at $1.3275, the notional value of the trade will be $13,275 (10,000 × $1.3275). Keep in mind that U.S. brokerage firms offer leverage of 50 to 1; accordingly, a trader could hypothetically purchase 10,000 Euro at $1.3275 and experience the gains or losses of the notional value ($13,275) with as little as $265.50 in a trading account (that is, (1/50) × 13,275).
• If you buy a currency pair, you buy the base currency and sell the quote currency. Conversely, when you sell the currency pair, you sell the base currency and receive the quote currency. 
• For example, if the USD/EUR currency pair is quoted as being USD/EUR = 1.5 and you purchase the pair, this means that for every 1.5 Euros that you sell, you purchase (receive) US$1. If you sold the currency pair, you would receive 1.5 Euros for every US$1 you sell. The inverse of the currency quote is EUR/USD, and the corresponding price would be EUR/USD = 0.667, meaning that US$0.667 would buy 1 euro.

LIQUIDITY IN FX Market and Different Time Zones

• Liquidity in the FX market travels across the globe with the time zones. From a U.S. perspective, the trading day actually begins the night before in Sydney, Australia, at 5:00 pm Eastern; however, liquidity doesn't tend to show up until the Tokyo open a few hours later.
• At 3:00 am Eastern, the London markets open, and the last to open is New York at 8:00 am local time. As you can see, there is plenty of action around the clock; the most liquidity can be found during the overlapped time between the London and New York sessions, approximately 8:00 am to 12:00 PM Eastern Time.

Decimal Precision in FX Trading

• Currency pairs are quoted in bids and asks, with the smallest increment of price referred to as a pip. In most cases, a pip is 1/10,000 or 0.0001 of a 5-digit price quote; there are typically four digits to the right of the decimal and one to the left. For example, you might see the ask price of the GBP/USD pair priced at 1.5910, where the last digit in the quote represents the pip.
• The exception to the 5-digit quote format is the Yen, which consists of 4 digits with two of them to the right of the decimal point and two to the left. You might see the last trade in the USD/YEN at 82.17.
• All other pairs and crosses are quoted to four decimal places. For instance, the Australian dollar (AUD)/USD is sold at 1.0469

All yen (JPY) pairs and crosses are quoted to two decimal places. For instance, the US dollar (USD)/JPY is bought at 90.25.

According to data from triennial survey by Bank of International settlements, London is by far the world's largest currency trading market with daily turnover in 2010 estimated at $1.854 trillion, more than that of the next three markets New York, at $904 billion, Tokyo at $312 billion and Singapore at $266 million - combined. Among the Banks, the leading Foreign Exchange Traders in 2012 are Barclays with 10.5% of market share, Deutsche with 9.8%, Citigroup with 9.3%, UBS with 8.2%, HSBC with 7.6% and JP Morgan with 7.5%

To conclude, FX is a dynamic market that relies on margins. The advent of electronic FX dealing systems has revolutionized this market and reduced a gamut of risks that were present in earlier days of manual dealers. The presence of real time payments settlements systems and the ability of banks to do cross border business with their correlation banks have further enhanced the efficiency, speed and accuracy in FX trading.

Thanks

Himanshu Sanguri