Overview of Forex Trading Systems

Basic Currency Trading Rules

Forex currency trading system involves an over the counter market where buyers and sellers interact by exchanging currencies at floating exchange rate through telephone or internet. Any transaction involves buying and selling of currencies simultaneously.

In a forex market you buy a strong currency and sell off the weaker one. In a forex currency trading system, trading is always done in pairs like USD/JPY, USD/Euro etc. Once you buy a stronger currency you expect that the market price will get modified so that the currency bought appreciates in value relative to the currency you have sold. So you automatically secure a profit by buying the currency that is stronger and can buy more goods and services at the same rate.

So you buy a currency that shows a trend of appreciation in the market and by buying it the demand for the currency can increase and the probability of the currency to appreciate in future also increases. So the currency naturally appreciates and becomes stronger. In a forex currency trading system, a forex trader takes advantage of this situation to sell off the weaker currency he holds and buy the currency that shows strong potential of appreciation in near future. If the transaction is reversed then you incur a loss.

When you are buying a currency you are automatically taking along position i.e. you anticipate that the currency will appreciate more in near future. When you sell it off you know that there is no chance for the currency to become strong immediately and thus you take a short position.

In a forex currency trading system, you can buy or sell a currency pair and not close the trade by buying and selling equivalent, less or greater amount of what you have bought and sold in exchange. So the position for trade is open and you can be affected by the profit or loss you earn from market fluctuations in the same currency pair.

Direct, Indirect, and Cross Rates

The International Standards Organization uses codes to abbreviate the currency pairs like USD/JPY which means US dollar vs. Japanese Yen. A currency exchange, which is a ratio of one currency compared or valued against its pair or couple and the exchange rate is always quoted for this currency pair.

If you want to buy currencies in a forex currency trading system, the exchange rate signifies how much you will pay for obtaining one unit of the base currency. If you want to sell it off, then the exchange rate signifies how much you will receive by selling one unit of the same base currency.

A 118.48/53 implies the bid price vs. the ask price for USD/JPY. Here USD is the base currency. This implies that the bid price is the price that you quote for selling one unit of the base currency. The base price represents the price you actually obtain by for one unit of the base currency. So 118.48 refer to what you get in JPY when you sell one unit of USD. This is the bid price. And 118.53 refer to what you have to pay in JPY to obtain one unit of USD. So this is the ask price.

In a forex currency trading system, spread is the difference between the bid price and ask price and the spread obtained here is 5 pips or 0.5. This might appear quite small but in reality a 1 pip higher or lower implies a huge gain or loss of the base currency in the inter bank market.

If the spread between the bid price and the ask price reduces to is zero then the market is often referred to as the choice market. This implies that at any point of time, the currencies can be bought and sold for the same price. The forex market at times closely resembles the choice market. This is true only when currency pairs are traded with a spread of only a fraction of a percent. This is possible when the market is extremely liquid and it includes a limited number of intermediaries. The spread between the USD and EUR is usually only 1 basis point, or 0.01% which is close to being referred to as the choice market.

The global forex currency trading system considers US dollar as the base currency. So, of the other currencies are traded against US dollars. The rate of exchange is referred to as direct rate. So when we see USD/CAD = 1.4500 this implies that 1 unit of USD is equivalent to 1.4500 Canadian Dollars (CAD) or in other words 1 UDS can buy 1.4500 CAD.

Indirect rates refer to the market rates for those currency pairs that include US dollar but the other currency in the pair currencies is not traded or valued against USD i.e. where USD is not the base currency but a quote currency or the secondary currency. These are British pound (GBP), Australian Dollar (AUD), New Zealand Dollar (NZD) and Euro dollar (EUR). So when we say GBP/USD = 1.5800, then we mean 1 GBP is equivalent to 1.5800 USD i.e. one GBP can buy 1.5800 USD.

When pair of currencies traded in a In a forex currency trading system does not include the U.S. dollar, then the market rate for currency trading is referred to as the cross rate. Traditionally you convert your foreign currency first into USD and then into the desired currency. The cross rate helps traders to skip this step. The GBP/JPY cross implies that you can directly convert money without having converted it into USD.

A few example of non-US Dollar currencies traded directly, are GBP/EUR or EUR/CHF and GBP/JPY. There are many currency pairs in cross currency where Euro is the base currency. These are EUR/ CAD, EUR/JPY, EUR/GBP and EUR/CHF.

Triangular Arbitrage

In triangular arbitrage, you are converting one currency to another and again converting this to a third currency and, finally, converting it back to the original currency within a short time span. You can secure riskless profit in this process when the currency's exchange rates do not exactly match up.

Online traders can benefit maximum from this opportunity as this is facilitated best in an automated process and lasts for only a very few seconds.  If you hold $1 million and the exchange rates prevailing in the forex market are: USD/GBP = 1.6939, EUR/USD = 0.8631 and EUR/GBP = 1.4600.

Now, what is the arbitrage opportunity under these exchange rate conditions and what do you actually gain assuming that this process involves no cost or taxes? You can sell dollars for euros i.e. $1 million x 0.8631 = 863,100 euros

You can sell euros for pounds i.e. 863,100/1.4600 = 591,164.40 pounds

You can sell pounds for dollars: 591,164.40 x 1.6939 = $1,001,373 dollars

So the difference is the gain from this arbitrage which is $1,001,373 - $1,000,000 = $1,373 in riskless profit.

Forex Market Orders

The orders that are executed immediately in a forex currency trading system at prevailing market rates are referred to as market orders. Limit orders refer to future trade conditions that do not offset the current position of the trader. In this case the currency pair is traded when particular desired exchange rates are reached.

For Current / Open Positions:

When the trader clears his position by buying or selling a pair as it reaches the desired exchange rate and closes the deal by locking in the profit then such a condition is referred to as a Take-Profit order. This also implies that you are long on the currency pair that you are trading. So you lock into the anticipated appreciated value and close your position.

Stop-Loss orders are used by a trader to limit his losses beyond a point. You are actually shorting the pair anticipating a loss and close your deal. You are safe from losing if there is a probability of further decline in price.

Spot Deal / Market

In a forex currency trading system, spot trade or cash trades are settled on the spot or immediately in the market as opposed to future deals. A spot deal is a bilateral contract between two parties one receiving a specified amount of a given currency and another delivering it at an exchange rate that is mutually agreed upon. The settlement dates are generally within two business days after the deal date.

Spot trades are just opposite to future trades that might take longer periods to close the deal and obtain the payments after the deal. Spot deals require immediate settlements otherwise would lead to loss of the trader and he is expected to be compensated for time value for the belated settlement. The settlement is done electronically and thus is instantaneous.

Authorized Forex Dealer

Dealing in foreign exchange requires that the trade is properly executed through financial institutions or individuals that have received authorization or permission from a regulatory or controlling body. In a forex currency trading system, it is also important to ensure that these dealings are conducted in a legal way. The National Futures Association is the regulatory body of United States that ensures legal foreign exchange practices.

The authorized forex dealers are screened through a set of rigorous selection procedures. The stages involve registration and strong enforcement of regulations upon approval.

The NFA was created in 1982. Through the execution and enforcement of regulatory behavior, the NFA shields traders and investors from counterfeit and fraudulent futures activities. It also acts as a mediator and arbitrator for addressing investors problems in the futures forex currency trading system.