Course 1. Forex and CFD market basics

course 1 of 4

The foreign exchange market, or Forex, is a global over-the-counter market for exchanging currencies. It has no single trading venue: deals are struck directly between participants through a network of electronic systems. Average daily turnover runs to several trillion dollars, making it the largest financial market in the world. This course explains how the market is structured and what determines the result of a trade.

Open an account

lesson 1.1

Market participants differ in the purpose of their transactions, and that explains why prices move.

Central banks: They set monetary policy and, when necessary, intervene in the currency market. By influence they are the largest participant: a change in the policy rate can shift an exchange rate by several per cent.
Commercial and investment banks: They account for the bulk of trading volume. They handle client flows and trade on their own account.
Corporations: They buy and sell currency to settle contracts and hedge currency risk. Their deals are driven by business needs rather than speculation.
Institutional investors: Funds, insurers and pension companies that reallocate capital between countries.
Retail traders: They make up a small share of turnover, trade through brokers and mostly use leverage.

lesson 1.2

The market runs around the clock five days a week, but activity is unevenly distributed.

Session	Hours	Characteristics
Asian sessionTokyo and Sydney	01:00 to 10:00 CET	Low volatility, narrow ranges. The Australian and New Zealand dollars and the Japanese yen are active.
European sessionLondon and Frankfurt	09:00 to 18:00 CET	Peak trading volume. The euro, pound sterling and Swiss franc are active.
American sessionNew York	14:30 to 23:00 CET	High volatility. The US dollar and Canadian dollar are active.

The overlap of the London and New York sessions from 14:30 to 18:00 CET provides the deepest liquidity of the day and the tightest spreads.

lesson 1.3

A currency pair shows how many units of the quote currency one unit of the base currency is worth.

In the quote EUR/USD = 1.0850, the euro is the base currency and the dollar is the quote currency. One euro is worth 1.0850 dollars.

Buying a pair means buying the base currency with the quote currency; selling is the reverse. That is why there is no falling direction on the currency market in the usual sense: when you sell EUR/USD, you are buying the dollar.

Pair type	Examples	Characteristics
Majors	EUR/USD, GBP/USD, USD/JPY, USD/CHF, USD/CAD, AUD/USD, NZD/USD	Maximum liquidity, minimal spreads.
Crosses	EUR/GBP, EUR/JPY, GBP/JPY, AUD/JPY	Do not include the US dollar. Wider spreads, sharper moves.
Exotics	USD/TRY, USD/ZAR, USD/MXN	Wide spreads, high volatility, risk of price gaps.

lesson 1.4

At any moment there are two prices for an instrument.

Bid is the price at which you sell. Ask is the price at which you buy. Ask is always higher than Bid.

The spread is the difference between them. It is the main transaction cost of a trade.

Example

EUR/USD is quoted at 1.08501 to sell and 1.08511 to buy. The spread is one pip.

Ask 1.08511 − Bid 1.08501 = 0.00010 = 1 pip

The key consequence: a position opens immediately with a negative result equal to the spread. If you buy at the Ask and sell straight away at the Bid, you lose the spread. To break even, the price must travel the width of the spread in your favour.

What the spread depends on.

The liquidity of the instrument: the spread on EUR/USD is tighter than on USD/TRY.
The time of day: spreads are wider during the Asian session and at the market open.
Macroeconomic releases: at the moment of publication the spread widens several times over.
The account type: on commission-based accounts the spread starts from zero.

lesson 1.5

A pip is the standard unit of price change. For most pairs it is the fourth decimal place; for pairs with the Japanese yen, the second.

Modern platforms display fractional pips, i.e. the fifth decimal place, or the third for yen pairs. A move from 1.08501 to 1.08511 is one full pip, or ten fractional pips.

The value of a pip depends on the position size and the quote currency. For a standard lot of 100,000 units of the base currency on a pair quoted in US dollars, one pip is worth 10 dollars.

Lot	Volume	Pip value
Standard (1.00)	100,000 units	10 dollars
Mini (0.10)	10,000 units	1 dollar
Micro (0.01)	1,000 units	10 cents

If the quote currency is not the US dollar, the pip value is converted into the account currency at the current exchange rate.

lesson 1.6

Leverage is the ratio between the size of a position and the own funds required to open it. Leverage of 1:30 means that a position of 30,000 euros requires 1,000 euros of collateral.

Margin is the amount blocked on the account against an open position. It is neither a commission nor a payment: the margin is released back into free funds when the position is closed.

Required margin formula: volume in lots multiplied by the contract size, multiplied by the price and divided by the leverage.

Margin = Lots × Contract size × Price / Leverage

Example.

A 0.5-lot position on EUR/USD at a price of 1.0850 with leverage of 1:30. The calculation: 0.5 multiplied by 100,000 multiplied by 1.0850 equals 54,250; divided by 30 equals 1,808 dollars.

0.5 × 100,000 × 1.0850 = 54,250 → 54,250 / 30 = 1,808 USD

Leverage increases the position size available with the capital you have. It does not increase your profit by itself; it scales both profit and loss proportionally. The statement "high leverage is dangerous" is imprecise: what is dangerous is a large position size. Leverage merely removes the limit on that size.

An example that shows the point.

A deposit of 1,000 euros and an open position of one lot on EUR/USD. A move of 100 pips against you produces a loss of 1,000 euros and the account is wiped out. This happens identically at leverage of 1:30 and at 1:500. The only difference is that at 1:30 you simply would not have been able to open such a position.

1 lot × 100 pips × 10 EUR = 1,000 EUR = the entire deposit

Key metrics

Balance: Funds taking into account closed trades only.
Equity: Balance plus the floating result of open positions.
Used margin: The amount blocked against open positions.
Free margin: Equity minus used margin.
Margin level: Equity divided by used margin, multiplied by one hundred per cent.Margin level = Equity / Used margin × 100%

lesson 1.7

A swap is a credit or debit for holding a position past the end of the trading day. Its economic basis is the interest rate differential between the two currencies in the pair.

When you buy EUR/USD, you effectively hold euros and borrow dollars. If the euro rate is lower than the dollar rate, the difference is debited from your account. If it is higher, it is credited.

What you need to know in practice.

The swap is charged at the end of the trading day by server time, usually at midnight Central European Time.
On Wednesday a triple swap is charged, covering the rollover over the weekend.
The swap can be negative in both directions, because the broker adds its own mark-up to the market rate differential.
When a position is held for a long time, the swap becomes a significant cost.

Example.

A negative swap of 2.50 euros per night on one lot. Over a month of holding, which is roughly thirty-four charges including triple Wednesdays, the cost comes to about 85 euros. For a position targeting a 50-pip move, i.e. 500 euros, that is seventeen per cent of the target profit.

2.50 EUR × 34 ≈ 85 EUR → 85 / 500 = 17% of target profit

lesson 1.8

A market order is executed immediately at the current price. It is used when you need to enter right now.

Type	Description
Buy Limit	Buy at a price below the current one. Used when a bounce from support is expected.
Sell Limit	Sell at a price above the current one. Used when a bounce from resistance is expected.
Buy Stop	Buy at a price above the current one. Used when trading an upward breakout.
Sell Stop	Sell at a price below the current one. Used when trading a downward breakout.
Stop Loss	Closes the position when the price moves against you. Mandatory in every trade.
Take Profit	Closes the position when the target is reached, without manual monitoring.
Trailing Stop	Moves the stop along behind the price, protecting accumulated profit in a trend.

lesson 1.9

Market execution is a model in which the order is filled at the best available price at the moment it reaches the server. If the price changed while the order was in transit, the trade opens at the new price. There are no requotes asking you to confirm the price under this model.

Slippage is the difference between the expected and the actual execution price. It can be negative or positive. It is most likely during periods of low liquidity and when macroeconomic statistics are released.

Execution quality is affected by:

The distance between your computer and the trading server
Your internet speed
Market depth in the instrument at that particular moment
The order size

self-check

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1.Which participant has the greatest influence on the currency market?