One way to think of a country’s currency is the same
way equity investors think of stocks. Higher stock
prices typically reflect investor confidence in a company’s future. Likewise, higher currency values
typically reflect investor sentiment in the health of
that country’s economy relative to other countries.
Earlier in 2010, when word spread that the U.S.
Federal Reserve was planning to buy back Treasury
bonds, the U.S. dollar (USD) sank. By October
2010, the greenback had buckled to new 15-year lows
against the Japanese yen. By buying bonds, the Fed
signaled to investors that it was taking serious action
to keep interest rates in check. Lower rates in the U.S.
make the dollar less interesting relative to other currencies. That is, as rates or yields fall, banks and other
investors will move money into financial systems that
offer higher rates. For instance, if rates are low in the
U.S., investors might move money into Australia and
invest in higher-yielding Australian bonds.
Capital movements across borders are like tides
that flow in the ocean. These shifts of assets are powerful forces that drive currencies higher and lower.
Economic data and interest rates are the key fundamental drivers for this capital movement. As a result,
trends can last months or even years and provide both
short- and long-term profit opportunities in the currency markets.
FIRST, THE NU TS AND BOLTS
Trading FX is essentially pairs trading. You are buying
one currency and selling another. If you buy the
EUR/USD pair, for example, you are long the euro and
short the US dollar. Some of the more actively traded
pairs today include the USD/JPY, GBP/USD, and
EUR/JPY. Major currency pairs consist of any pair
with two of the currencies listed below. All other pairs
are considered “exotic.”
USD U.S. dollar
JPY Japanese yen
AUD Australian dollar
CAD Canadian dollar
GBP British pound
CHF Swiss franc
DKK Danish krone
NZD New Zealand dollar
NOK Norwegian krone
SEK Swedish krona
The minimum price movement in a currency market is called a pip or tick. For example, let’s say the
quote for EUR/USD is 1.4165 bid to 1.4175 ask. Since
one pip is 0.0001, this means that the difference in
price between the bid and ask is ten pips, which is
another way of saying that the difference in price for
€10,000 (euros) is $100 (U.S. dollars). Just as with
stocks, investors can buy at the ask and sell on the bid.
For many currencies, the pip is equal to 1/100 of a
cent, or 0.0001. This seems like a small amount, but a
standard trade is $100,000, so a 0.0001 pip equals $10.
If you capture 10 pips on a trade, you’ve made $100.
I T’S ALL ABOU T THE LEVERAGE
Forex trading at TD Ameritrade offers a fixed leverage
of 50 to 1 on major pairs and 20 to 1 on exotic pairs.
The rules surrounding leverage on FX are a bit different than margin on equities. Let’s consider an example: Suppose the EUR/USD currency pair is trading at
1.41750 bid to 1.41850 ask, and you buy the pair on
the 1.41850 ask. You are now long the euro and short
the dollar. You’re anticipating the euro will bounce
higher against the dollar. Assume the euro gains
against the dollar, and the quote is now 1.42050 bid to
1.42150 ask. You sell the position at the 1.42050 bid
price. On a $100,000 transaction size, you net 20 pips,
or a $200 profit. If you’re trading on TD Ameritrade’s
non-commission feed, your transaction costs are
included in the quotes.
($1.42050 – $1.41850) X 100,000
= 0.002 = 20 pips = $200
On the other hand, if the euro loses against the
dollar, and the quote is lower, say 1.41650 bid to
1.41750 ask, on a $100,000 transaction size, you're
down 20 pips, or a $200 loss.
($1.41650 – $1.41850) X 100,000
= -0.002 = -20 pips = -$200
What’s important to understand about FX leverage
is that you don’t need to put up the entire $100,000 to
trade EUR/USD. The leverage varies by firm, but it’s
not uncommon to see leverage rates of 5 to 1 or even
50 to 1 (as with TD Ameritrade). If, for example,
you’ve put down $2,000 (50 to 1) and capture 20 pips