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Forex

  • Can I trade a currency when its main market is closed?
    A:

    In the forex market, currencies from all over the world can be traded at all times of the day. The forex market is very liquid, and the increased availability of advanced technology and information processing has only increased the number of participants.

    Although markets in many foreign countries are closed at the time when North American markets are open, trading on foreign currencies can still take place. While the majority of trading on a particular currency occurs when its main market is open, many other banks around the world hold foreign currencies, enabling them to continue to be traded at times when the main market is closed. For example, the North American markets are open when the Japanese markets are closed, but North American traders are still able to buy and sell Japanese yen through their brokerages and banks. However, the market for Japanese yen is more liquid at times when the Japanese market is open.

    Certain currencies have very low rates of demand for exchange purposes. As a result, these currencies can be difficult to trade and can usually only be traded in specific banks. Because currency trading does not take place on a regulated exchange, there is no assurance that there will be someone who will match the specifications of your trade. However, the major currencies of the world, such as the American dollar, the euro and the Japanese yen, are the most widely available.

    For further reading, see Getting Started In Forex, A Primer On The Forex Market, Wading Into The Currency Marketand Common Questions About Currency Trading.


  • How are Bollinger Bands® used in forex trading?
    Bollinger Bands are popular with technical analysts and traders in all markets, including forex. Since traders of currency look for very incremental moves to profit, recognizing volatility and trend changes quickly is essential. Bollinger Bands help by signaling changes in volatility. For generally steady ranges of a security, such as many currency pairs, Bollinger Bands act as relatively clear signals for buying and selling. This can result in stop-outs and frustrating losses, though, so traders consider other factors when placing trades in relation to the Bollinger Bands.

    Setting Limits

    First, a trader must understand how Bollinger Bands are set up. There is an upper and lower band, each set at a distance of two standard deviations from the security's 21-day simple moving average. Therefore, the Bands show the volatility of the price in relation to the average, and traders can expect movements in price anywhere between the two bands. Forex traders can use the bands to place sell orders at the upper band limit and buy orders at the lower band limit. This strategy works well with currencies that follow a range pattern, but it can be costly to a trader if a breakout occurs.

    Reading Volatility

    Since Bollinger Bands measure deviation from the average, they react and change shape when price fluctuations increase or decrease. Increased volatility is nearly always a sign that new normals will be set, and traders can capitalize using Bollinger Bands. When the Bollinger Bands converge on the moving average, indicating lower price volatility, it is known as "the Squeeze." This is one of the most reliable signals given by Bollinger Bands, and it works well with forex trading. A Squeeze was seen in the USD/JPY currency pair on Oct. 31, 2014. News that the Bank of Japan would be increasing its stimulus bond buying policy sparked the trend change. Even if a trader did not hear about this news, the trend change could be spotted with the Bollinger Band Squeeze.

    Backup Plans

    Sometimes reactions are not as intense, and traders can miss profits by setting orders directly on the upper and lower Bollinger Bands. Therefore, it is wise to determine entry and exit points near these lines to avoid disappointment. Another Forex trading strategy to work around this is to add a second set of Bollinger Bands placed only one standard deviation from the moving average, creating upper and lower channels. Then, buy orders are placed within the lower zone and sell orders in the upper zone, increasing execution probability.

    There are several other specific strategies used in currency trading with Bollinger Bands, such as the Inside Day Bollinger Band Turn Trade and Pure Fade Trade. In theory, these are all profitable trades, but traders must develop and follow the methods exactly in order for them to pan out.


  • How are interest rates related to open market operations?
    A:

    Interest rates are indirectly affected by open market operations (OMOs). OMOs are a tool in monetary policy allowing a central bank to control the money supply in an economy. Under contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in money supply. Changes to the money supply affect the rates at which banks borrow reserves from one another due to the law of supply and demand.

    The federal funds rate is the interest rate at which banks borrow reserves from one another overnight to meet the reserve requirement. This is the interest rate that the Fed targets when conducting OMOs. Short-term interest rates offered by banks are based on the federal funds rate, so the Fed can indirectly influence interest rates faced by consumers and businesses by the sale and purchase of securities.

    In 1979, the Fed began using OMOs as a tool under Chairman Paul Volcker. To combat inflation, the Fed began selling securities in an attempt to reduce the money supply. The amount of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 18%. Conversely, the Fed purchased over $1 trillion in securities in response to the 2008 recession. This expansionary policy, called quantitative easing, increased the money supply and drove down interest rates. Low interest rates helped stimulate business investment and demand for housing.


  • How are NDFs (non-deliverable forwards) priced
    A:

    The price of non-deliverable forward contracts, or NDFs, is commonly based on an interest rate parity formula used to calculate equivalent returns over the term of the contract based on the spot price exchange rate and interest rates for the two currencies involved, although a number of other factors can also affect the price.

    Non-deliverable Forwards

    NDFs are a foreign exchange agreement most commonly used when one of the currencies involved is not freely traded in the forex market and is thus considered "non-deliverable." They are most often used by companies seeking to hedge exposure to currency risk when transacting business in countries whose currency is not freely traded. NDFs are usually short-term contracts between two parties in which the difference between the spot price exchange rate on the contract settlement date and the previously agreed upon exchange rate is settled between the two parties for a notional amount of money. NDFs are typically priced and settled in U.S. dollars.

    Pricing NFD contracts

    Interest rates are the most common primary determinant of the pricing for NDFs. Most NDFs are priced according to an interest rate parity formula. This formula is used to estimate equivalent interest rate returns for the two currencies involved over a given time frame, in reference to the spot rate at the time the NDF contract is initiated. Other factors that can be significant in determining the pricing of NDFs include liquidity, counterparty risk and trading flows between the two countries involved. In addition, speculative positions in one currency or the other, onshore interest rate markets, and any differential between onshore and offshore currency forward rates can also affect pricing. NDF prices may also bypass consideration of interest rate factors and simply be based on the projected spot exchange rate for the contract settlement date.


  • How can I trade in cross currency pairs if my forex account is denominated in U.S. dollars?
    A:

    The forex market allows individuals to trade on nearly all of the currencies in the world. However, most of the trading is done on a group of currencies called the "majors", which include the U.S. dollar, the euro, the British pound, the Japanese yen and the Canadian dollar.

    Currencies are traded against one another and are subsequently quoted in pairs. An example of a currency pair is the EUR/USD, which is one of the most widely traded currency pairs. Because the U.S. dollar is one of the most traded currencies, it is included in the majority of the pairs that are traded. However, other widely traded pairs that do not include the U.S. dollar, such as the GBP/JPY currency pair, are called cross currencies.

    Most American forex investors will deposit U.S. dollars into their margin accounts. However, just because they have U.S. dollars doesn't mean that they are limited to trading currency pairs that include the U.S. dollar. American investors are still able to trade on cross currencies, they just have to make two trades instead of one.

    For example, assume that an investor with an account denominated in U.S. dollars wants to buy the Japanese yen against the British pound. To do this, he or she would have to trade the GBP/JPY currency pair by purchasing British pounds with U.S. dollars. Once this trade is complete, the investor can then use the British pound to complete the trade on the GBP/JPY currency pair. Because two trades need to be completed, the broker calculates a margin for both trades and adds them together. To avoid having to do this, brokers will often accept margin deposits in foreign currencies such as the British pound. Usually investors who have currency available in foreign bank accounts are able to use this option.

    To learn more, see A Primer On The Forex Market, Getting Started in Forex and Wading Into The Currency Market.


  • How do central banks acquire currency reserves and how much are they required to hold?
    A:

    A currency reserve is a currency that is held in large amounts by governments and other institutions as part of their foreign exchange reserves. Reserve currencies usually also become the international pricing currencies for products traded on the global market such as oil, gold and silver. Currently, the U.S. dollar is the primary reserve currency used by other countries.

    Manipulating reserve levels can enable a country's central bank to intervene against volatile fluctuations in currency by affecting the exchange rate and increasing the demand for and value of the country's currency. Reserves act as a shock absorber against factors that can negatively affect a country's exchange rates and, therefore, the central bank uses reserves to help maintain a steady rate.

    The most popular currency held in reserves is the U.S. dollar. In the U.S., almost all banks are part of the Federal Reserve system and it is required that a certain percentage of their assets be deposited with the regional Federal Reserve Bank. The reserve requirements are established by the Board of Governors and by varying the requirements, the Fed is able to influence the money supply. Reserves also keep the banks secure by reducing the risk that they will default by ensuring that they maintain a minimum amount of physical funds in their reserves. This increases investor confidence and stabilizes the economy.

    Basically, the Board of Governors of a central bank meets and decides on the reserve requirements as a part of monetary policy. The amount that a bank is required to hold in reserve fluctuates depending on the state of the economy and what the Board of Governors determines as the optimal level.






    For further reading, see Formulating Monetary Policy, Get To Know The Major Central Banks and What Are Central Banks?



  • How do companies benefit from interest rate and currency swaps?
    A:

    In general, both interest rate and currency swaps have the same benefits for a company. First, let's define interest rate and currency swaps.

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount. However, in an interest rate swap, the principal amount is not actually exchanged. In an interest rate swap, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate, which is usually LIBOR.

    A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract.

    In the case of companies, these derivatives help to limit or manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are often used because a domestic firm can usually receive better rates than a foreign firm.

    For example, suppose company A is located in the U.S. and company B is located in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a swap in order to take advantage of the fact that each company has better rates in its respective country. These two companies could receive interest rate savings by combining the privileged access they have in their own markets.

    Swaps also help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Swapping allows companies to revise their debt conditions to take advantage of current or expected future market conditions. Currency and interest rate swaps are used as financial tools to lower the amount needed to service a debt as a result of these advantages.

    Currency and interest rate swaps allow companies to more efficiently navigate the global markets by bringing together two parties that have an advantage in different markets. The benefits that a company receives from participating in a swap far outweigh the costs, although there is some risk associated with the possibility that the other party will fail to meet its obligations.

    For further reading, see "Corporate Use of Derivatives for Hedging" and "How Does the Foreign-Exchange Market Trade 24 Hours a Day?"


  • How do I convert one type of currency to another, such as dollars to pounds?
    A:

    Currency can be converted using an online currency exchange or it can be performed manually. To use either method, you must first look up the exchange rate using an online exchange rate calculator or by contacting your bank. The rates charged by your bank may differ from those you see online because banks earn small profits on exchanges, whereas online rates are the same as those quoted between banks.

    In addition, it is important to note that the exchange rate you receive when trading one currency against another probably will differ from the rate you will obtain during the actual conversion of one currency into another at a local bank. Traders can access the tight bid-ask spreads that are posted by banks, but visitors to foreign countries who require local currency will pay slightly higher prices for the same currency. For example, an online EUR/USD (euro against the dollar) may appear as 1.5560 - 1.5563, which means banks are selling to each other at 1.5563, but are buying from each other at 1.5560. The spread of three pips (points) is the profit banks realize for facilitating this transaction.

    Let's conduct a dollar-to-euro conversion, for example. First, look up the exchange rate online using a website such as xe.com, which will be quoted as the amount $1 can buy in euros or as the amount one euro will buy in dollars. If $1 buys 0.6250 euros, then $10,000 would equal 6,250 euros (because 10,000 x 0.6250 = 6,250). If the quote states that one euro buys $1.60, then $10,000 still would equal 6,250 euros (because 10,000/1.6000 = 6,250).

    (For more on this topic, see "The Impact of Currency Conversions.")


  • How do I use an arbitrage strategy in forex trading?
    A:

    Forex arbitrage is a risk-free trading strategy that allows retail forex traders to make a profit with no open currency exposure. The strategy involves acting on opportunities presented by pricing inefficiencies in the short window they exist. This type of arbitrage trading involves the buying and selling of different currency pairs to exploit any pricing inefficiencies. We can better understand how this strategy works through the following example.

    [If you are new to Forex trading and are looking to enter the market, make sure you're prepared by taking Investopedia Academy's Forex Trading for Beginners course. With real-time trading examples and simple to use strategies, you'll learn the right way to trade currency.]

    Example: Arbitrage Currency Trading

    The current exchange rates of the EUR/USD, EUR/GBP, GBP/USD pairs are 1.1837, 0.7231, and 1.6388, respectively. In this case, a forex trader could buy one mini-lot of EUR for $11,837 USD. The trader could then sell the 10,000 Euros for 7,231 British pounds. The 7,231 GBP could then be sold for $11,850 USD for a profit of $13 per trade, with no open exposure as long positions cancel short positions in each currency. The same trade using normal lots (rather than mini-lots) of 100,000 would yield a profit of $130.

    The act of exploiting the pricing inefficiencies will correct the problem so traders must be ready to act quickly is the case with arbitrage strategies. For this reason, these opportunities are often around for a very short time. Arbitrage currency trading requires the availability of real-time pricing quotes and the ability to act fast on opportunities. Forex arbitrage calculators are available to aid in this process of finding opportunities in a short window of time.

    Forex Arbitrage Calculator

    There are many tools available that can help find pricing inefficiencies, which otherwise can be time consuming. One of these tools is the forex arbitrage calculator, which provides retail forex traders with real-time forex arbitrage opportunities. Forex arbitrage calculators are sold through third parties and forex brokers. It is important to try out a demo account first, as all software programs and platforms used in retail forex trading are not one in the same. It is also worth sampling multiple products before deciding on one to determine the best calculator for your trading strategy.

    For further reading on the fundamentals of forex trading, see "Getting Started in Forex."


  • How do I use exponential moving average (EMA) to create a forex trading strategy?
    A:

    The exponential moving average (EMA) differs from a simple moving average (SMA) in two primary ways: more weight is given to the most recent data and the EMA reacts faster to recent price changes than the SMA.

    [Moving averages are a great way to see where prices are headed at a glance, but successful traders rely on a combination of technical indicators to make trades. Investopedia's Technical Analysis course provides a comprehensive overview of basic and advanced technical analysis techniques with over five hours of on-demand video, exercises, and interactive content.]

    The EMA is very popular in forex trading, so much that it is often the basis of a trading strategy. A common forex trading strategy that uses EMAs relies on selecting a shorter-term EMA and a longer-term EMA and then trade based on the position of the short-term EMA in relation to the long-term EMA. A trader enters buy orders when the short-term EMA crosses above the long-term EMA or enters sell orders when the short-term EMA crosses below the long-term EMA.

    For example, a trader might use crossovers of the 50 EMA by the 10 or 20 EMA as trading signals. Another strategy that forex traders use involves observing a single EMA in relation to price to guide their trading decisions. As long as the price remains above the chosen EMA level, the trader remains on the buy side; if the price falls below the level of the selected EMA, the trader is a seller unless price crosses to the upside of the EMA.

    The most commonly used EMAs by forex traders are the 5, 10, 12, 20, 26, 50, 100, and 200. Traders operating off of shorter timeframe charts, such as the five- or 15-minute charts, are more likely to use shorter-term EMAs, such as the 5 and 10. Traders looking at higher timeframes also tend to look at higher EMAs, such as the 20 and 50. The 50, 100 and 200 EMAs are considered especially significant for longer-term trend trading.


  • How do I use Fibonacci Clusters for creating a forex trading strategy?
    A:

    Fibonacci trading tools – such as retracements, arcs, fans and clusters – are predicated on the mathematical properties of the Fibonacci sequence. Believing that trading (like human nature) groups into approximately measurable patterns that bear some relationship with derivations of the Fibonacci, traders and analysts use Fibonacci clusters to see which support and resistance levels have a higher probability of reversal than others.

    Forex traders implement a Fibonacci cluster analysis just like traders of traditional stocks do. They identify different groups of confirmed Fibonacci retracements over time and center breakout and reversal trades along the areas of greatest concentration. All Fibonacci tools are implemented manually and subjectively based on the individual investor. All support and resistance zones are in a sense subjective, but Fibonacci trading (like Elliott wave trading or other security-independent tools of analysis) magnifies this subjectivity. Traders and analysts are more likely to use clusters as a way to confirm support and resistance levels that have been signalled by another indicator.

    One common method is to combine an indicator that shows trading volume by price, maybe even another graph. This allows the trader to see which areas of high support and resistance also correlate with high trading volume.

    Traditionally, Fibonacci clusters are represented on a currency pair price chart as a series of shaded bars along the far right y-axis. Whenever a retracement level functions as a support or resistance line, a line is added to the cluster column. Each overlapping retracement level makes the corresponding section on the cluster column darker. Areas of the highest concentration are considered to be more significant support and resistance zones.


  • How do I use Fibonacci Retracements to create a forex trading strategy?
    A:

    Forex traders use Fibonacci retracements to pinpoint where to place orders for market entry, for taking profits and for stop-loss orders. Fibonacci levels are commonly used in forex trading to identify and trade off of support and resistance levels.

    Fibonacci retracements identify key levels of support and resistance. Fibonacci levels are commonly calculated after a market has made a large move either up or down and seems to have flattened out at a certain price level. Traders plot the key Fibonacci retracement levels of 38.2%, 50% and 61.8% by drawing horizontal lines across a chart at those price levels to identify areas where the market may retrace to before resuming the overall trend formed by the initial large price move. The Fibonacci levels are considered especially important when a market has approached or reached a major price support or resistance level.

    The 50% level is not actually part of the Fibonacci number sequence, but is included due to the widespread experience in trading of a market retracing about half a major move before resuming and continuing its trend.

    The strategies forex traders employ using Fibonacci levels include:

    • Buying near the 38.2% retracement level with a stop-loss order placed a little below the 50% level.

    • Buying near the 50% level with a stop-loss order placed a little below the 61.8% level.

    • When entering a sell position near the top of the large move, using the Fibonacci retracement levels as take profit targets.

    • If the market retraces close to one of the Fibonacci levels and then resumes its prior move, using the higher Fibonacci levels of 161.8% and 261.8% to identify possible future support and resistance levels if the market moves beyond the high/low that was reached prior to the retracement.


  • How do I use moving average to create a forex trading strategy?
    A:

    A forex trader can create a simple trading strategy to take advantage trading opportunities using just a few moving averages (MAs) or associated indicators.

    Moving averages are a frequently used technical indicator in forex trading, especially over 10, 50, 100, and 200 periods. MAs are used primarily as trend indicators and also identify support and resistance levels. The two most common MAs are the simple moving average (SMA), which is the average price over a given number of time periods, and the exponential moving average (EMA), which gives more weight to recent prices.

    Below we've outlined several trading strategies designed for intraday as well as long-term trading.

    Moving Average Trading Strategy

    This moving average trading strategy uses the EMA, because this type of average is designed to respond quickly to price changes. Here are the strategy steps.

    • Plot three exponential moving averages – a five-period EMA, a 20-period EMA, and 50-period EMA – on a 15-minute chart.
    • Buy when the five-period EMA crosses from below to above the 20-period EMA, and the price, five, and 20-period EMAs are above the 50 EMA.
    • For a sell trade, sell when the five-period EMA crosses from above to below the 20-period EMA, and both EMAs and the price are below the 50-period EMA.
    • Place the initial stop-loss order below the 20-period EMA (for a buy trade), or alternatively about 10 pips from the entry price.
    • An optional step is to move the stop-loss to break even when the trade is 10 pips profitable.
    • Consider placing a profit target of 20 pips, or alternatively exit when the five-period falls below the 20-period if long, or when the five moves above the 20 when short.

    Moving average crossover strategy on eurusd chart.

    Forex traders often use a short-term MA crossover of a long-term MA as the basis for a trading strategy. Play with different MA lengths or time frames to see which works best for you.

    Moving Average Envelopes Trading Strategy

    Moving average envelopes are percentage-based envelopes set above and below a moving average. The type of moving average that is set as the basis for the envelopes does not matter, so forex traders can use either a simple, exponential or weighted MA. 

    Forex traders should test out different percentages, time intervals, and currency pairs to understand how they can best employ an envelope strategy. It is most common to see envelopes over 10- to 100-day periods and using bands that have a distance from the moving average of between 1-10% for daily charts. If day trading, the envelopes will often be much less than 1%. On the one-minute chart below, the MA length is 20 and the envelopes are 0.05%. Settings, especially the percentage, may need to be changed from day to day depending on volatility. Use settings that align the strategy below to the price action of the day.

    Ideally, trade only when there is a strong overall directional bias to the price. Then, only trade in that direction. If the price is in an uptrend, consider buying once the price approaches the middle-band (MA) and then starts to rally off of it. In a strong downtrend, short when the price approaches the middle-band and then starts to drop away from it.

    Using envelopes to trade forex.

    Once a short is taken, place a stop-loss one pip above the recent swing high that just formed. Once a long trade is taken, place a stop-loss one pip below the swing low that just formed. Consider exiting when the price reaches the lower band on a short trade or the upper band on a long trade. Alternatively, set a target that is at least two times the risk. For example, if risking five pips, set a target 10 pips away from the entry.

    Moving Average Ribbon Trading Strategy

    The moving average ribbon can be used to create a basic forex trading strategy based on a slow transition of trend change. It can be utilized with a trend change in either direction (up or down).

    The creation of the moving average ribbon was founded on the belief that more is better when it comes to plotting moving averages on a chart. The ribbon is formed by a series of eight to 15 exponential moving averages (EMAs), varying from very short-term to long-term averages, all plotted on the same chart. The resulting ribbon of averages is intended to provide indication of both trend direction and strength of trend. A steeper angle of the moving averages – and greater separation between them, causing the ribbon to fan out or widen – indicates a strong trend.

    Traditional buy or sell signals for the moving average ribbon are the same type of crossover signals used with other moving average strategies. Numerous crossovers are involved, so a trader must choose how many crossovers constitute a good trading signal.

    An alternate strategy can be used to provide low-risk trade entries with high profit potential. The strategy outlined below aims to catch a decisive market breakout in either direction, which often occurs after a market has traded in a tight and narrow range for an extended period of time.

    To use this strategy, consider the following steps:

    • Watch for a period when all of (or most of) the moving averages converge closely together when the price flattens out into sideways range. Ideally, the various moving averages are so close together that they form almost one thick line, showing very little separation between the individual moving average lines.
    • Bracket the narrow trading range with a buy order above the high of the range and a sell order below the low of the range. If the buy order is triggered, place an initial stop-loss order below the low of the trading range; if the sell order is triggered, place a stop just above the high of the range.

    Using ribbon consolidation strategy to trade forex.

    Moving Average Convergence Divergence Trading Strategy

    The moving average convergence divergence (MACD) histogram shows the difference between two exponential moving averages (EMA), a 26-period EMA, and a 12-period EMA. Additionally, a nine-period EMA is plotted as an overlay on the histogram. The histogram shows positive or negative readings in relation to a zero line. While most often used in forex trading as a momentum indicator, the MACD can also be used to indicate market direction and trend.

    There are various forex trading strategies that can be created using the MACD indicator. Here is an example.

    • Trade the MACD and signal line crossovers. Using the trend as the context, when the price is trending higher (MACD should be above zero line), buy when the MACD crosses above the signal line from below. In a downtrend (MACD should be below zero line), short sell when the MACD crosses below the signal line. 
    • If long, exit when the MACD falls back below the signal line.
    • If short, exit when the MACD rallies back above the signal line.
    • At the outset of the trade, place a stop-loss just below the most recent swing low if going long. When going short, place a stop-loss just above the most recent swing high.

    MACD crossover strategy for forex.

    Guppy Multiple Moving Average

    The Guppy multiple moving average (GMMA) is composed of two separate sets of exponential moving averages (EMAs). The first set has EMAs for the prior three, five, eight, 10, 12 and 15 trading days. Daryl Guppy, the Australian trader and inventor of the GMMA, believed that this first set highlights the sentiment and direction of short-term traders. A second set is made up of EMAs for the prior 30, 35, 40, 45, 50 and 60 days; if adjustments need to be made to compensate for the nature of a particular currency pair, it is the long-term EMAs that are changed. This second set is supposed to show longer-term investor activity.

    If a short-term trend does not appear to be gaining any support from the longer-term averages, it may be a sign the longer-term trend is tiring out. Refer back the ribbon strategy above for a visual image. With the Guppy system, you could make the short-term moving averages all one color, and all the longer-term moving averages another color. Watch the two sets for crossovers, like with the Ribbon. When the shorter averages start to cross below or above the longer-term MAs, the trend could be turning.

    The Bottom Line

    There are multiple ways to use a moving average as part of a forex trading strategy. Moving average trading indicators can be used on their own, or as envelopes, ribbons, or convergence-divergence strategies (to name some examples). Before using any of these indicators or strategies, adjust the settings to verify that the strategies provide favorable results on the forex pairs and time frames you trade. Moving averages are lagging indicators, which means they don't predict where price is going, they are only providing data on where price has been. Moving averages, and the associated strategies, tend to work best in strongly trending markets. 


  • How do I use On-Balance Volume (OBV) to create a forex trading strategy?
    A:

    On-Balance Volume, or OBV, is a technical indicator that operates based on the assumption that price movements are preceded by volume movements. Traders use this tool to forecast future trends and gauge bull and bear strengths, particularly in the short-term. Forex markets are well-suited for the type of analysis OBV aims to provide since currency pair trading involves so much short-term arbitrage opportunities.

    Forex trading volume acts a little differently than traditional stock trading volume, because there are two competing monetary mediums rather than the supply and demand of a trading instrument as expressed through a single currency. The assumptions made in the OBV formula make it uniquely able to provide a traditional volume reading, however.

    Mechanically, the OBV is not difficult to understand. Whenever one day's trading price closes above the trading price for the day before, trading volume is added to a running OBV line. Conversely, volume is subtracted from the running total when the current day's prices close below the close for the day before; you want to enter trends that have the OBV's support and attempt to short trends that do not.

    Contrast the OBV trendline with the currency pair price action trendline. Divergence occurs when the OBV pattern does not move in concert with the price, while confirmation of trend strength can be signaled when the two move together. If the volume does not support a new price movement, you may want to avoid the trade because there is a stronger chance of the price retracing quickly.

    Remember that the OBV is a leading indicator, and it can be balanced by lagging indicators. Add a moving average line to the OBV to look for OBV line breakouts; you can confirm a breakout in the price if the OBV indicator makes a concurrent breakout.


  • How do I use Relative Vigor Index (RVI) to create a forex trading strategy?
    A:

    A forex trading strategy designed to make maximum profits from a long-term uptrend can be created using the Relative Vigor Index, or RVI, in conjunction with other technical indicators. The RVI compares closing price to price range and provides a reading of the strength of price movement up or down. Higher values for the RVI indicate increasing trend strength, while lower values indicate a lessening of momentum. As a momentum indicator, the slope of the RVI often changes direction ahead of price.

    In a long-term uptrend, there are back-and-forth movements of price as it advances in the direction of the overall trend, retraces downward and then turns back to advance further in the direction of the existing trend. The RVI can be employed by a trader who, rather than using a buy-and-hold trend trading strategy, wants to maximize profits by moving in and out of buy positions in accord with peaks and retracements that occur within the trend.

    Other technical indicators are used to confirm trading signals given by the RVI. The strategy is as follows:

    • Once the trader has a long position established in an overall uptrend, he or she monitors the RVI for bearish divergence from price. Price makes a new high, but the RVI does not make a corresponding new high.
    • Confirmation of an impending retracement is sought by using another technical indicator, the Relative Strength Index, or RSI. If the RSI indicates overbought conditions in the market by readings above 70, this is taken as a confirming signal of the RVI divergence indication. The trader takes profit on half of his or her existing buy position.
    • Assuming a retracement occurs, the trader looks to re-establish his or her full long position when the RVI shows a bullish divergence from price and the RSI indicates oversold conditions.
    • The trader continues taking half profits, then resumes a full long position while the overall uptrend remains intact, as determined by price remaining above the 100-period moving average, or MA. On a close below the 100 MA, the trader closes out his or her entire position.

  • How do I use Stochastic Oscillator to create a forex trading strategy?
    A:

    The stochastic oscillator is a momentum indicator that is widely used in forex trading to pinpoint potential trend reversals. This indicator measures momentum by comparing closing price to the trading range over a given period.

    The charted stochastic oscillator actually consists of two lines: the indicator itself is represented by %K, and a signal line reflecting the three-day simple moving average (SMA) of %K, which is called %D. When these two lines intersect, it signals that a trend shift may be approaching. In a chart displaying a pronounced bullish trend, for example, a downward cross through the signal line indicates that the most recent closing price is closer to the lowest low of the look-back period than it has been in the previous three sessions. After sustained upward price action, a sudden drop to the lower end of the trading range may signify that bulls are losing steam.

    Like other range-bound momentum oscillators, such as the relative strength index (RSI) and Williams %R, the stochastic oscillator is also useful for determining overbought or oversold conditions. Ranging from 0 to 100, the stochastic oscillator reflects overbought conditions with readings over 80 and oversold conditions with readings under 20. Crossovers that occur in these outer ranges are considered particularly strong signals. Many traders ignore crossover signals that do not occur at these extremes.

    When creating trade strategy based on the stochastic oscillator in the forex market, look for a currency pair that displays a pronounced and lengthy bullish trend. The ideal currency pair has already spent some time in overbought territory, with price nearing a previous area of resistance. Look for waning volume as an additional indicator of bullish exhaustion. Once the stochastic oscillator crosses down through the signal line, watch for price to follow suit. Though these combined signals are a strong indicator of impending reversal, wait for price to confirm the downturn before entry – momentum oscillators are known to throw false signals from time to time.

    Combining this setup with candlestick charting techniques can further enhance your strategy and provide clear entry and exit signals.


  • How do I use the relative strength index to create a forex trading strategy?
    A:

    The relative strength index (RSI) is most commonly used to indicate temporary overbought or oversold conditions in a market. An intraday forex trading strategy can be devised to take advantage of indications from the RSI that a market is overextended and therefore likely to retrace.

    The RSI is a widely used technical indicator and an oscillator that indicates a market is overbought when the RSI value is over 70 and indicates oversold conditions when RSI readings are under 30. Some traders and analysts prefer to use the more extreme readings of 80 and 20. A weakness of the RSI is that sudden, sharp price movements can cause it to spike repeatedly up or down, and, thus, it is prone to giving false signals.

    Also, it is not uncommon for price to continue to extend well beyond the point where the RSI first indicates the market as being overbought or oversold. For this reason, a trading strategy using the RSI works best when supplemented with other technical indicators.

    Here are some steps to implementing an intraday forex trading strategy that employs the RSI and at least one additional confirming indicator:

    1. Monitor the RSI for readings indicating the market is overbought or oversold.
    2. Consult other momentum or trend indicators for confirming signs of an impending retracement. For example, if the RSI shows oversold readings, a retracement to the upside is anticipated.

    Only initiate a trade looking to profit from a retracement if one these additional conditions is met:

    1. The moving average convergence divergence (MACD) has shown divergence from price (for example, if price has made a new low, but the MACD has not and has turned from a downslope to an upslope).
    2. The average directional index (ADX) has turned in the direction of a possible retracement.

    If the above conditions are met, then initiate the trade with a stop-loss order just beyond the recent low or high price, depending on whether the trade is a buy trade or sell trade, respectively. The initial profit target can be the nearest identified support/resistance level.

    For further reading on the RSI and forex indicators, see "Momentum and the Relative Strength Index" and "4 Types of Indicators FX Traders Must Know."


  • How do I use the Zig Zag Indicator to create a forex trading strategy?
    A:

    The Zig Zag indicator, named for the pattern of straight lines that appear to zig zag across a technical analysis chart, operates as a filter for directional changes in price movements. Technical analysts and forex traders apply the Zig Zag filter to remove unnecessary noise from the price chart; the goal is to focus on the important trends, not insignificant fluctuations. This indicator should never act as a trading system on its own. Instead, the Zig Zag indicator is best used to highlight important patterns and confirm possible trend reversals.

    How the Zig Zag Indicator Works

    The Zig Zag indicator is easy to understand and apply. Price changes below a specific threshold, normally 10% or 20%, are removed from trendlines through a filtration process. Most trading software or online trading platforms have simple input fields that allow you to set the parameters of your own Zig Zag preferences.

    Keep in mind that the higher you set the price change threshold, the less sensitive the indicator becomes. If you set too low of a spot, it results in an ineffective Zig Zag since not enough noise is removed. Too restrictive and you may miss profitable price trend data. Most default settings have the threshold between 8% and 15%.

    Trading Forex With the Zig Zag

    The Zig Zag tool is designed to be complementary and should not be the focal point of a forex trading strategy. It is most commonly used in conjunction with Fibonacci or Elliot Wave trading systems. Swing traders love the Zig Zag because it helps them analyze entries on retracements.

    The Zig Zag indicator is there to apply consistency to trading signals. This should translate into a more consistent application of other trade strategies. Whatever trading strategy you use, keep in mind that the Zig Zag is a lagging indicator, which means does not predict anything on its own. The forex market is very fast paced, so try to complement it with a system that offers leading signals.


  • How do national interest rates affect a currency's value and exchange rate?
    A:

    All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely exist in foreign exchange. Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange rate with other currencies is the result of a number of interrelated elements that reflect the overall financial condition of a country in respect to other nations.

    Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

    This simple occurrence is complicated by a host of other factors that impact currency value and exchange rates. One of the primary complicating factors is the relationship that exists between higher interest rates and inflation. If a country can achieve a successful balance of increased interest rates without an accompanying increase in inflation, its currency's value and exchange rate is more likely to rise.

    Interest rates alone do not determine the value of a currency. Two other factors – political and economic stability and the demand for a country's goods and services – are often of greater importance. Factors such as a country's balance of trade between imports and exports can be a crucial factor in determining currency value. That is because greater demand for a country's products means greater demand for the country's currency as well. Favorable numbers, such as the gross domestic product (GDP) and balance of trade are also key figures that analysts and investors consider in assessing a given currency.

    Another important factor is a country's level of debt. High levels of debt, while manageable for shorter time periods, eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.

    The recent history of the U.S. clearly illustrates the critical importance of a country's overall perceived political and economic stability in relation to its currency valuations. As U.S. government and consumer debt has risen, the Federal Reserve has moved to maintain interest rates near zero in an attempt to stimulate the U.S. economy. The Fed has since moved to incrementally raise interest rates to 1.50% (as of February 2018) in response to a recovering economy, but rates are still very low compared to pre-financial crisis levels.

    Even with historically low interest rates, the U.S. dollar has enjoyed favorable exchange rates in relation to the currencies of most other nations. This is partially due to the fact that the U.S. retains, at least to some extent, the position of being the reserve currency for much of the world. Also, the U.S. dollar is still perceived as a safe haven in an economically uncertain world. This factor, even more so than interest rates, inflation or other considerations, has proven to be significant for maintaining the relative value of the U.S. dollar.


  • How do traders and analyst create profitable Swing Trading strategies in forex?
    A:

    There are numerous opportunities for creating profitable swing trading strategies in the forex market. Although many swing traders focus on anticipating the breakout after a period of consolidation, channel trading is arguably one of the simplest swing strategies to implement. When a currency pair trades within a defined price channel, whether bullish, bearish or trendless, the consistent oscillation of price between support and resistance levels offers multiple opportunities within a relatively short period.

    To take advantage of this swing trading strategy in the forex market, first look for currency pairs trading within a channel. A price channel is defined by drawing trendlines between two or more swing highs and swing lows. On a bearish chart, this means price oscillates between lower highs and lower lows, forming a downward sloping channel. On a bullish chart, the opposite is true. If a currency pair exhibits no clear trend and price moves between two horizontal lines of support and resistance, it is said to be range-bound. Once the channel is identified, implementing this swing trading strategy is as simple as going long when price touches the support level and selling long positions or entering short positions when it touches resistance.

    For example, assume the USD/EUR currency pair levels out after an uptrend and trades sideways for a period of weeks. After three similar swing highs and lows, price establishes a channel between 1.51 and 1.60. As price approaches the lower channel boundary at 1.51, enter using a market order or a limit order set at this support level. A stop loss set below support can help protect your investment from an unexpected breakout. As price swings back up through the channel, prepare to exit your long position with a limit order set at the 1.60 resistance level. A short position can also be entered at this point in preparation for the downswing. Set stop-loss orders just above resistance.


  • How do you lose money in the Forex market?
    A:

    All trades made in the forex market are made in pairs. In other words, one currency is always quoted against another currency, for example the U.S. Dollar against the Japanese yen or the U.S. Dollar against the euro. When a trader buys the dollar against the yen, he or she is hoping or speculating that the dollar will increase in value, while the Yen will decrease. Conversely, when the trader sells the U.S. Dollar against the Japanese yen, he is speculating that the dollar will decrease in value while the yen increases in value. If he buys the dollar-yen, but the yen increases in value, the trader will lose money, since he now owns dollars which have decreased in value compared with the yen.


    A trader can minimize his or her losses by predefining where to exit a position, should the trade not work out as intended. The trader can leave an order in the market with his or her broker, and the order will be automatically executed if the parameters are met. Hence, a trader can decide how much of a loss to sustain before exiting the position. This type of order is known as a stop loss order, and it is considered the most popular risk management tool. Traders who do not leave stop loss orders in the market can sustain large losses if their position moves in the wrong direction, especially if it is a leveraged position. In some cases an account can be so leveraged that an adverse move can cause the trader's account to fall into the negative. (For more, see Place Forex Orders Properly.)


    This question was answered by Selwyn Gishen.


  • How do you make money trading money?
    A:

    Investors can trade almost any currency in the world, and may do so through foreign exchange (forex) if they have enough financial capital to get started. In order to make money in forex you should be aware that you are taking on a speculative risk — you are betting that the value of one currency will increase relative to another.

    Examples of Currency Trading

    It's first important to note that currencies are traded, and priced, in pairs. For example, you may have seen a currency quote for a EUR/USD pair of 1.1256. In this example, the base currency is the euro and the U.S. dollar is the quote currency.

    In all currency quote cases, the base currency is worth one unit, and the quoted currency is the amount of currency that one unit of the base currency can buy. Based on our previous example, all that means is that one euro can buy 1.1256 U.S. dollars. How an investor makes money in forex is either by appreciation in the value of the quoted currency, or by a decrease in value of the base currency.

    [ Like any asset market, the forex market has it's own nuances and best practices. If you're looking to actively trade currency, Investopedia's Forex Trading for Beginners course gives you a start-to-finish guide on how the forex works, ideal trading strategies and real-time examples of trades. ]

    Another way to look at currency trading is to think about the position an investor is taking on each currency pair. The base currency can be thought of as a short position because you are "selling" the base currency to purchase the quoted currency. In turn, the quoted currency can be seen as the long position on the currency pair.

    In our example above, we see that one euro can purchase $1.1256 and vice versa. To purchase the euros, the investor must first go short on the U.S. dollar in order to go long on the euro. To make money on this investment, the investor will have to sell back the euros when their value appreciates relative to the U.S. dollar.

    For instance, let's assume the value of the euro appreciates to $1.1266. On a lot of $100,000 the investor would gain US$100 ($112,660 - $112,560) if they sold the euros at this exchange rate. Conversely, if the EUR/USD exchange rate fell by 10 pips to $1.1246, then the investor would lose $100 ($112,460 - $112,560).

    Beginners who want to learn more about active trading in the forex should read "A Primer on the Forex Market," "Forex: Money Management Matters" and "Getting Started in Forex."


  • How Do You Use a Back-to-Back Loan?
    A:

    Back-to-back loans, also called parallel loans, are a financial move used by companies to curb foreign-exchange rate risk or currency risk. They are loan arrangements where companies loan each other money in their own currency. For example, if a U.S. company is engaged in a back-to-back loan arrangement with a Mexican company, the U.S. company borrows pesos from that company while the same Mexican company borrows dollars from the U.S. company.

    Usually, if a company needs money in another currency, the company heads to the currency market to trade for it. The issue with trading currency is that a currency with high fluctuations can result in great loss for the company. A back-to-back loan is very convenient for a company that needs money in a currency that is very unstable. When companies engage in back-to-back loans, they usually agree on a fixed spot exchange rate, usually the current one. This eliminates the risk associated with the volatility of exchange rates because the companies are repaying their loans based on the agreed-upon fixed rate.

    Avoiding Currency Risk

    This is how back-to-back loans work: To avoid currency or exchange risk, companies look for other companies in another country and engage in back-to-back lending. For example, if U.S company X, has a subsidiary in Japan, Y, that needs 1,000 yen, company X will look for a Japanese company with a subsidiary in the U.S., Z, that needs $1,000. A back-to-back loan occurs when company X loans Z $1,000 and the Japanese company loans Y 1,000 yen. The two companies usually agree on the duration of the loan and at the end of the loan term, they swap currencies again. Back-to-back loans are rarely used today but they still remain an option for companies seeking to borrow foreign currency.

    Although back-to-back loans have been around since at least the 18th century, they really only gained prominence in the 1970s when companies in the U.K. used them to avoid stiff foreign investment taxes. They have fallen out of usage today in favor of currency swaps and foreign exchange derivatives. In a currency swap, the actual principal amount isn't swapped, but used to calculate interest payments paid to each party. The companies are not required to list these foreign exchange transactions on the balance sheet. (See also: Foreign Exchange Risk.)

    This question was answered by Chizoba Morah.


  • How Does Leverage Affect Pip Value?
    A:

    A standard forex account has specific lots and pip units. A lot is the minimum quantity of a security that may be traded, while a pip is the smallest amount by which a currency quote can change. Typically, one lot is worth $100,000 and a pip unit is stated in the amount of $0.0001 for U.S.-dollar related currency pairs. This is the most common pip unit and it is used for almost all currency pairs. Pip value is the effect that a one-pip change has on a dollar amount. It is important to note that pip value does not vary based on the amount of leverage used, but rather that the amount of leverage you have affects the pip value.

    Leverage is the amount of money you are able to spend as a result of borrowing investment capital. Basically, the more leveraged you are, the riskier your position—a decrease of a few pips could mean losing all of the money in your account. For example, with a standard lot size of $100,000, pip value is $10 ($100,000 x 0.0001). If your account contains $10,000 and you have a leverage of 150:1, then you will have $1.5 million ($10,000 x 150) or 15 lots ($15,000,000/$100,000) that you can use for investing. It would be extremely risky to use the entire $1.5 million that you have available because each pip is worth $150 and you could clean out your account just by losing 67 pips ($10,000/150). Although there is large downside risk to having high leverage, there is also a large upside gain—if you were to make 67 pips instead, your account value would double, and you would rake in 100% returns in one day!

    Increasing your leverage increases the volatility of your position because small changes in pip value will result in larger fluctuations in your account value. (See also: Getting Started in Forex, A Primer on the Forex Market, Common Questions About Currency Trading and Using Currency Correlations to Your Advantage.)


  • How does margin trading in the forex market work?
    A:

    A margin account, at its core, involves borrowing to increase the possible return on investment. Investors often use margin accounts when they want to invest in equities by using the leverage of borrowed money to control a larger position than they'd otherwise by able to control with their own invested capital.

    These margin accounts are operated by the investor's broker and are settled daily in cash. Margin accounts are not limited to equities – they are also used by currency traders in the forex market.

    To get started, investors interested in trading in the forex markets must first sign up with either a regular broker or an online forex discount broker. Once an investor finds a proper broker, a margin account must be set up. A forex margin account is very similar to an equities margin account – the investor is taking a short-term loan from the broker. The loan is equal to the amount of leverage taken on by the investor.

    An investor must first deposit money into the margin account before a trade can be placed. The amount that needs to be deposited depends on the margin percentage that is agreed upon between the investor and the broker. For instance, accounts that will be trading in 100,000 currency units or more, the margin percentage is usually either 1% or 2%.

    So, for an investor who wants to trade $100,000, a 1% margin would mean that $1,000 needs to be deposited into the account. The remaining 99% is provided by the broker. No interest is paid directly on this borrowed amount, but if the investor does not close their position before the delivery date, it will have to be rolled over. In that case, interest may be charged depending on the investor's position (long or short) and the short-term interest rates of the underlying currencies.

    In a margin account, the broker uses the $1,000 as a security deposit of sorts. If the investor's position worsens and his or her losses approach $1,000, the broker may initiate a margin call. When this occurs, the broker will usually instruct the investor to either deposit more money into the account or to close out the position to limit the risk to both parties.

    To learn more, see "Getting Started in Forex," "A Primer on the Forex Market" and "Getting Started in Foreign Exchange Futures."


  • How does the balance of payments impact currency exchange rates?
    A:

    A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true when a fluctuation in relative currency strength can alter the balance of payments. There are two different and interrelated markets at work: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).

    These conditions only exist under a free or floating exchange rate regime. The balance of payments does not impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the international exchange of funds.

    The world has not operated under any single rules-based or fixed exchange-rate system since the end of Bretton Woods in the 1970s.

    To explain further, suppose a consumer in France wants to purchase goods from an American company. The American company is not likely to accept euros as payment; it wants U.S. dollars. Somehow the French consumer needs to purchase dollars (ostensibly by selling euros in the forex market) and exchange them for the American product. Today, most of these exchanges are automated through an intermediary so that the individual consumer doesn't have to enter the forex market to make an online purchase. After the trade is made, it is recorded in the current account portion of the balance of payments.

    The same holds true for investments, loans or other capital flows. American companies normally do not want foreign currencies to finance their operations, thus their expectation for foreign investors to send them dollars. In this scenario, capital flows between countries show up in the capital account portion of the balance of payments.

    As more U.S. dollars are demanded to satisfy the needs of foreign investors or consumers, upward pressure is placed on the price of dollars. Put another way, it costs relatively more to exchange for dollars, in terms of foreign currencies.

    The exchange rate for dollars may not actually rise if other factors are concurrently pushing down the value of dollars. For example, expansionary monetary policy might increase the supply of dollars.

    For further reading, see "Understanding Capital and Financial Accounts in the Balance of Payments."


  • How does the balance of trade impact currency exchange rates?
    A:

    The balance of trade influences currency exchange rates through its effect on the supply and demand for foreign exchange. When a country's trade account does not net to zero – that is, when exports are not equal to imports – there is relatively more supply or demand for a country's currency, which influences the price of that currency on the world market.

    Currency exchange rates are quoted as relative values; the price of one currency is described in terms of another. For example, one U.S. dollar might be equal to 11 South African rand. In other words, an American business or person exchanging dollars for rand would buy 11 rand for every dollar sold, and a South African would buy $1 for every 11 rand sold.

    These relative values are influenced by the demand for currency, which is in turn influenced by trade. If a country exports more than it imports, there is a high demand for its goods, and thus, for its currency. The economics of supply and demand dictate that when demand is high, prices rise and the currency appreciates in value. In contrast, if a country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In the case of currency, it depreciates or loses value.

    For example, let's say that candy bars are the only product on the market and South Africa imports more candy bars from the U.S. than it exports, so it needs to buy more dollars relative to rand sold. South Africa's demand for dollars outstrips America's demand for rand, meaning that the value of the rand falls. In this situation, we'll surmise that the rand might fall to 15 relative to the dollar. Now, for every $1 sold, an American gets 15 rand. To buy $1, a South African has to sell 15 rand.

    The relative attractiveness of exports from that country also grows as a currency depreciates. For instance, assume an American candy bar costs $1. Before depreciation, a South African could buy an American candy bar for 11 rand. Afterward, the same candy bar costs 15 rand, a huge price increase. On the other hand, a South African candy bar costing 5 rand has become much cheaper by comparison: $1 now buys three South African candy bars instead of two.

    South Africans might start buying fewer dollars because American candy bars have become quite expensive, and Americans might start buying more rand because South African candy bars are now cheaper. This, in turn, begins to affect the balance of trade; South Africa starts exporting more and importing less, reducing the trade deficit.

    Our example assumes that the currency is on a floating regime, meaning that the market determines the value of the currency relative to others. In cases where one or both currencies are fixed or pegged to another currency, the exchange rate does not move so readily in response to a trade imbalance.


  • How does the foreign exchange market trade 24 hours a day?
    A:

    The forex market is the largest financial market in the world, trading around $1.5 trillion each day. Trading in the forex is not done at one central location, but is conducted between participants by phone and electronic communication networks (ECNs) in various markets around the world.

    The market is open 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST on Friday because currencies are in high demand. The international scope of currency trading means that there are always traders across the globe who are making and meeting demands for a particular currency.

    [Note: If you're interested in day trading in the forex market, Investopedia's Forex Trading For Beginners course provides an excellent introduction to day trading to help you get started on the right foot.]

    Currency is also needed around the world for international trade, by central banks and global businesses. Central banks have particularly relied on foreign-exchange markets since 1971 — when fixed-currency markets ceased to exist because the gold standard was dropped. Since that time, most international currencies have been "floated" rather than tied to the value of gold.

    Economic and political instability and infinite other perpetual changes also affect the currency markets. Central banks seek to stabilize their country's currency by trading it on the open market and keeping a relative value compared to other world currencies. Businesses that operate in multiple countries seek to mitigate the risks of doing business in foreign markets and hedge currency risk.

    Businesses enter into currency swaps to hedge risk which gives them the right, but not necessarily the obligation, to buy a set amount of a foreign currency for a set price in another currency at a date in the future. They are limiting their exposure to large fluctuations in currency valuations through this strategy.

    The ability of the forex to trade over a 24-hour period is due in part to different international time zones and the fact trades are conducted over a network of computers, rather than any one physical exchange that closes at a particular time. For instance, when you hear that the U.S. dollar closed at a certain rate, it simply means that that was the rate at market close in New York. That is because currency continues to be traded around the world long after New York's close, unlike securities.

    Securities such as domestic stocks, bonds and commodities are not as relevant or in need on the international stage and thus are not required to trade beyond the standard business day in the issuer's home country. The demand for trade in these markets is not high enough to justify opening 24 hours a day due to the focus on the domestic market, meaning that it is likely that few shares would be traded at 3 a.m. in the U.S.

    The forex market can be split into three main regions: Australasia, Europe and North America, with several major financial centers within each of these main areas. For example, Europe is comprised of major financial centers such as London, Paris, Frankfurt and Zurich. Banks, institutions and dealers all conduct forex trading for themselves and their clients in each of these markets.

    Each day of forex trading starts with the opening of the Australasia area, followed by Europe and then North America. As one region's markets close another opens, or has already opened, and continues to trade in the forex market. These markets will often overlap for a few hours, providing some of the most active period of forex trading. So for example, if a forex trader in Australia wakes up at 3 a.m. and wants to trade currency, they will be unable to do so through forex dealers located in Australasia, but they can make as many trades as they want through European or North American dealers.

    The Bottom Line

    Currency is a global necessity for central banks, international trade and global businesses, and therefore requires a 24-hour market to satisfy the need for transactions across various time zones. In sum, it's safe to assume that there is no point during the trading week that a participant in the forex market will not potentially make a currency trade.

    (For further reading, see "Getting Started in Forex.")


  • How is rollover interest calculated?
    A:

    In the forex market, all trades must be settled in two business days. Traders who want to extend their positions without having to settle them must close their positions before 5pm Eastern Standard Time on the settlement day and re-open them the next trading the day. This pushes out the settlement by another two trading days. This strategy, called a rollover, is created through a swap agreement and it comes with a cost or gain to the trader, depending on prevailing interest rates.

    The forex market works with currency pairs and is quoted in terms of the quoted currency compared to a base currency. The investor borrows money to purchase another currency, and interest is paid on the borrowed currency and earned on the purchased currency, the net effect of which is rollover interest.

    In order to calculate the rollover interest, we need the short-term interest rates on both currencies, the current exchange rate of the currency pair and the quantity of the currency pair purchased. For example, assume that an investor owns 10,000 CAD/USD. The current exchange rate is 0.9155, the short-term interest rate on the Canadian dollar (the base currency) is 4.25% and the short-term interest rate on the U.S. dollar (the quoted currency) is 3.5%. In this case, the rollover interest is $22.44 [{10,000 x (4.25% - 3.5%)}/(365 x 0.9155)].

    The number of units purchased is used because this is the number of units owned. The short-term interest rates are used because these are the interest rates on the currencies used within the currency pair. The investor in our example owns Canadian dollars, so he or she earns 4.25%, but must pay the borrowed U.S. dollar rate of 3.5%. The product of the difference in the numerator of the equation is divided by the product of the exchange rate and 365 because this puts our numerator into a daily figure. If, on the other hand, the short-term interest rate on the base currency is below the short-term interest rate on the borrowed currency, the rollover interest rate would be a negative number, causing a reduction in the value of the investor's account. Rollover interest can be avoided by taking a closed position on a currency pair.

    To learn more, see Getting Started In Forex and Floating And Fixed Exchange Rates.


  • How is spread calculated when trading in the forex market?
    A:

    First, remember that in the forex markets investors trade one currency for another. Therefore, currencies are quoted in terms of their price in another currency.

    In order to express this information easily, currencies are always quoted in pairs (e.g. USD/CAD). The first currency is called the base currency and the second currency is called the counter or quote currency (base/quote). For example, if it took C$1.20 to buy US$1, the expression USD/CAD would equal 1.2/1 or 1.2. The USD would be the base currency and the CAD would be the quote or counter currency.

    Now that we know how currencies are quoted in the marketplace, let's look at how we can calculate their spread. Forex quotes are always provided with bid and ask prices, similar to what you see in the equity markets. The bid represents the price at which the forex market maker is willing to buy the base currency (USD in our example) in exchange for the counter currency (CAD). Conversely, the ask price is the price at which the forex market maker is willing to sell the base currency in exchange for the counter currency. Forex prices are always quoted using five numbers; so, for this example, let's say we had a USD/CAD bid price of 120.00 and an ask of 120.05. Thus, the spread would be equal to 0.05, or $0.0005.

    To learn about the basics of the forex market, check out A Primer On The Forex Market and Getting Started In Forex.





  • How is the forex spot rate calculated?
    A:


    The forex spot rate is determined by supply and demand. Banks all over the world are buying and selling different currencies to accommodate their customers' requirements for trade or to exchange one currency into another.

    For example, an American bank receives a deposit from a German bank on behalf of their client who wants to buy something from a company in America. The German client has to pay the American supplier in dollars. The German client has euros and these euros need to be exchanged then for dollars. The German buyer will instruct his bank to exchange the euros to dollars and transfer the money to the U.S. supplier. If the bank doesn't have a supply of dollars, it will buy the dollars from another bank and sell euros.

    The sum total of all banks selling dollars and all banks buying dollars creates a supply and demand for U.S. Dollars. If the demand for dollars increases then the dollar will appreciate against other currencies. If the demand drops then the dollar depreciates against the other currencies. The rates are set by all the participating banks bidding and offering currencies all day long amongst each other. This is the interbank system and is the way currencies are traded and the way exchange rates are determined. (For more, see The Foreign Exchange Interbank Market.)

    This question was answered by Selwyn Gishen.


  • How often do exchange rates fluctuate?
    A:

    Exchange rates float freely against one another, which means they are in constant fluctuation. Currency valuations are determined by the flows of currency in and out of a country. A high demand for a particular currency usually means that the value of that currency will increase.

    Currency demand is driven by tourism, international trade, mergers and acquisitions, speculation, and the perception of safety in terms of geo-political risk. For example, if a company in Japan sells products to a company in the U.S. and the U.S.-based company has to convert dollars into Japanese yen to pay for the goods, the flow of dollars into yen would indicate demand for Japanese yen. If the total currency flow led to a net demand for Japanese yen, the currency would increase in value.

    [There are many reasons that exchange ranges fluctuate, including both fundamental and technical reasons. Investopedia's Technical Analysis course will show you how to capitalize on technical movements by effectively reading charts and using technical indicators. With over five hours of on-demand video, exercises, and interactive content, you'll learn both basic and advanced techniques to capitalize on opportunities and manage risk.]

    Currencies are traded around the clock – 24 hours per day. Even though trading hours vary – the morning in Tokyo occurs during U.S. nighttime – trade and banking continue around the world. Therefore, as banks around the world buy and sell currencies, the value of currencies remain in fluctuation. Interest rate adjustments in different countries have the greatest effect on the value of currencies, because investors typically gravitate toward safety with the highest yields. If an investor can earn 8.5% interest on deposits in the England, but can pay 1% interest for the use of money in Japan, then the investor would pay to borrow the Japanese yen in order to buy the British pound.

    (For more on this topic, see "Get to Know the Major Central Banks" and "6 Factors That Influence Exchange Rates.")


  • In the forex market, how is the closing price of a currency pair determined?
    A:

    The foreign exchange market, or forex, is the market in which the currencies of the world are traded by governments, banks, institutional investors and speculators. The forex is the largest market in the world and is considered a 24-hour market because currencies are traded around the world in various markets, providing traders with the constant ability to trade currencies. The forex opens at 5pm EST on Sunday and runs until 5pm EST on Friday, running 24 hours a day during this time. But between the Friday close and the Sunday open, the forex market does not trade.

    The opening prices for the week are the initial trading prices on Sunday and the closing prices for the week are those of the last trade on Friday. However, over the course of the week, there really are no closing prices for the forex as there is at least one market open at some place in the world at all times.

    However, we often hear quotes for the opening and closing prices for currency pairs in the financial media. For example, a news article might state how the U.S. dollar closed down against the Canadian dollar during trading on Wednesday. The price being quoted is the closing price for an individual market within the forex market. There are three main regions - North America, Asia and Europe - and within each there are several forex markets. In North America, the main market is in New York, in Asia it is in Tokyo and in Europe it is in London. There are many other individual markets within these regions that are part of the forex market, and each individual market has an open and close (i.e. does not trade 24 hours a day). The New York market, for example, trades from 8am EST until 3pm EST. In North American media, the closing price will often refer to the closing price of the New York forex market.

    While these quotes give financial-media users a sense of the current market, the quotes are not as accurate as the actual current market price. For any forex trader, the best forex closing price to use is the closing price of his or her transaction.

    For more information on the forex market, read Getting Started in Forex and A Primer on the Forex Market.


  • Is it possible to trade forex options?
    A:

    Yes. Options are available for trading in almost every type of investment that trades in a market. Most investors are familiar with stock or equity options, however options are available to the retail forex currency trader as well.

    Currency Option Trading
    There are two types of options primarily available to retail forex traders for currency option trading. The first is the traditional call or put option.

    The call gives the buyer the right to purchase a currency pair at a given exchange rate at some time in the future. The put option gives the buyer the right to sell a currency pair at a given exchange rate at some time in the future. Both the put and call options give investors a right to buy or sell, but there is no obligation. If the current exchange rate puts the options out of the money, then the options will expire worthless.

    Alternatively, the other type of option available to retail forex traders for currency option trading is the single payment options trading (SPOT) option. SPOT options have a higher premium cost compared to traditional options, but they are easier to set and execute. A currency trader buys a SPOT option by inputing a desired scenario (ex. "I think EUR/USD will have an exchange rate above 1.5205 15 days from now"), and a premium will be quoted. If the buyer purchases this option, then the SPOT will automatically pay out should the scenario occur. Essentially, the option is automatically converted to cash.

    Options are used by forex currency traders to make a profit or protect against a loss. It is also important to note that there is a wide variety of exotic options that can be used by professional forex traders, but most of these contracts are thinly traded because they are only offered over the counter. Because options contracts implement leverage, traders are able to profit from much smaller moves when using an options contract than in a traditional retail forex trade. When combining traditional positions with a forex option, hedging strategies can be used to minimize the risk of loss. Options strategies such as straddles, strangles and spreads are popular methods for limiting the potential of loss in a currency trade. (To learn more on this topic, see Exotic Options: A Getaway From Ordinary Trading.)

    Forex Options Online
    Not all retail forex brokers provide the opportunity for option trading within your accounts. Retail forex traders should be sure to research the broker they intend on using to determine whether everything that will be required is available. For forex traders who intend to trade forex options online, for either profit or risk management, having a broker that allows you to trade options alongside traditional positions is valuable. Alternatively, traders can open a separate account and buy options through a different broker.

    Because of the risk of loss when writing options, most retail forex brokers do not allow traders to sell options contracts without high levels of capital for protection.

    For more, see Getting Started In Forex Options.


  • Is scalping a viable forex trading strategy?
    A:


    Scalping in the forex market involves trading currencies based on a set of real-time analysis. The purpose of scalping is to make a profit by buying or selling currencies and holding the position for a very short time and closing it for a small profit. Many trades are placed throughout the trading day and the system that is used by these traders is usually based on a set of signals derived from technical analysis charting tools, and is made up of a multitude of signals, that create a buy or sell decision when they point in the same direction. A forex scalper looks for a large number of trades for a small profit each time.

    Forex Scalping System
    A forex scalping system can be either manual, where the trader looks for signals and interprets whether to buy or sell; or automated, where the trader "teaches" the software what signals to look for and how to interpret them. The timely nature of technical analysis makes real-time charts the tool of choice for forex scalpers.

    Forex Scalper
    The forex market is large and liquid; it is thought that technical analysis is a viable strategy for trading in this market. It can also be assumed that scalping might be a viable strategy for the retail forex trader. It is important to note though, that the forex scalper usually requires a larger deposit, to be able to handle the amount leverage they must take on to make the short and small trades worthwhile.

    For more, see our Forex Market Tutorial.






  • Is there a buy-and-hold strategy in forex, or is the only way to make money by trading?
    A:

    Typically there are different ways to trade in most markets. Traders have been classified into three groups, primarily based on the time frame they prefer to trade. For simplicity, we can label these three groups as day traders, swing traders and position traders. Some people consider a position's trade or buy-and-hold strategy as an investment, but in reality it is just a long term trade.

    Nevertheless, in the forex market, one can hold a position for as long as a few minutes to a few or more years. Depending on the goals of the trader, one can take a position based on the fundamental economic trends in one country versus another. For example, a long-term trade in the forex market, or a buy and hold position, if one prefers that term, would have been good for someone who had sold dollars to buy euros back in the early 2000's and then held on to that position for a few years. Suppose an American buys shares in a company in Europe, they will have pay for those shares in euros, thus there is a requirement to convert dollars into euros. Not only is the American speculating on the growth of the European company, but also on the appreciation of the euro against the dollar. In this example, the American may have benefited from an appreciating value of the shares that he or she bought, but also benefit from an appreciating currency. Of course, in the converse, had someone in Europe bought shares in a company like General Motors (NYSE:GM), they would have had to pay for those shares in dollars but would have lost value in both the shares and the currency during the same time period.

    If one wants to buy and hold a currency, one would possibly sell a currency that pays a low interest rate, such as the yen and buy a currency that pays a high interest rate, such as the Australian dollar. This would be considered a carry trade, where the trader will earn the interest differential between the two currencies. While he knows how much interest he will receive, he does not know how the two currencies will continue to perform against each other.

    Most of the Forex traders though, tend to be short term traders, constantly timing the market swings in the hope of profiting from doing so. (For more, see Forex Tutorial: The Forex Market.)





    This question was answered by Peter Cherewyk.




  • Is there a world currency? If so, what is it?
    A:

    T

    here is no such thing as a world currency. However, since World War II, the dominant or reserve currency of the world has been the U.S. dollar. At one time, all currencies were backed by gold, meaning that every country had to hold in reserve enough gold for all of the currency in circulation. In other words, gold was the standard by which all currencies were measured. After World War II, the United States became the world's largest and most dominant economy. Due to the global expansion that took place after the war, bank reserves did not hold enough gold reserves to back the growth of the currency, which was needed to finance the global expansion further. Consequently, the U.S. disconnected from the gold standard and began to print more paper money to finance the world's growth requirements. Because the U.S. was such a powerful economy, other countries agreed to accept the dollar as legitimate tender and followed suit to waiver the gold standard. Thus, the dollar became the most dominant currency and almost all commodities came to be quoted internationally in U.S. dollars.

    As time went by and other economies developed, so did the value of their currencies. Today, the other two major currencies are the euro (the common currency of many European member states) and the Japanese yen. While the U.S. dollar remains the reserve currency of the world, it has depreciated in value in recent years and, consequently, the euro has increased in importance. In fact, the world can be divided into three main currency blocks, with the Americas dealing mostly in dollars, Europe dealing in euros, and the Asian countries becoming more connected to the yen. It is no coincidence that the three largest economies - the U.S., Europe and Japan - also represent the three most dominant currencies.

    In the case of less dominant currencies, countries like Australia once had to do business with Japan by first doing business with the U.S. - converting its currency into U.S. dollars and then from U.S. dollars into Japanese yen. Today, there are many cross currencies, or instances when a currency pair is not associated with the U.S. dollar, allowing Australia to transact directly with Japan using AUD/JPY.

    (For more on this topic, see Global Trade and the Currency Market and The Gold Standard Revisited.)






  • Keynesian and Monetarist economics: How do they differ?
    A:

    Monetarist economics is Milton Friedman's direct criticism of Keynesian economics theory, formulated by John Maynard Keynes. Simply put, the difference between these theories is that monetarist economics involves the control of money in the economy, while Keynesian economics involves government expenditures. Monetarists believe in controlling the supply of money that flows into the economy, while allowing the rest of the market to fix itself. In contrast, Keynesian economists believe that a troubled economy continues in a downward spiral unless an intervention drives consumers to buy more goods and services.

    Both of these macroeconomic theories directly impact the way lawmakers create fiscal and monetary policies. If both types of economists were equated to motorists, monetarists would be most concerned with adding gasoline to their tanks, while Keynesians would be most concerned with keeping their motors running.

    Keynesian Economics, Simplified

    The terminology of demand-side economics is synonymous to Keynesian economics. Keynesian economists believe the economy is best controlled by manipulating the demand for goods and services. However, these economists do not completely disregard the role the money supply has in the economy and on affecting gross domestic product, or GDP. Yet, they do believe it takes a great amount of time for the economic market to adjust to any monetary influence.

    Keynesian economists believe in consumption, government expenditures and net exports to change the state of the economy. Fans of this theory may also enjoy the New Keynesian economic theory, which expands upon this classical approach. The New Keynesian theory arrived in the 1980s and focuses on government intervention and the behavior of prices. Both theories are a reaction to depression economics.

    Monetarist Economics Made Easy

    Monetarists are certain the money supply is what controls the economy, as their name implies. They believe that controlling the supply of money directly influences inflation and that by fighting inflation with the supply of money, they can influence interest rates in the future. Imagine adding more money to the current economy and the effects it would have on business expectations and the production of goods. Now imagine taking money away from the economy. What happens to supply and demand?

    Monetarist economics founder Milton Friedman believed monetary policy was so incredibly crucial to a healthy economy that he publicly blamed the Federal Reserve for causing the Great Depression. He implied it is up to the Federal Reserve to regulate the economy.

    Keynesian, Monetarist Theories in Politics

    Presidents and other lawmakers have applied multiple economic theories throughout history. Soon after the Great Depression, President Herbert Hoover failed in his approach to balance the budget, focusing primarily on the needs of businesses in a time of turmoil. President Roosevelt followed next and focused his administration's efforts on increasing demand and lowering unemployment. It is worth noting that Roosevelt's New Deal and other policies increased the supply of money in the economy.

    More recently, the 2007-08 financial crisis led President Obama and other lawmakers to address economic problems by bailing out banks and fixing underwater mortgages for government-owned housing. In these instances, it appears elements of Keynesian and Monetarist theories were used to reduce the national debt.


  • What am I buying and selling in the forex market?
    A:

    The forex market is the largest market in the world. According to the Triennial Central Bank Survey conducted by the Bank for International Settlements, the average daily trading volume reached $1.9 trillion in 2004. This huge trading volume provides the forex market with excellent liquidity, which benefits the large number of traders that invest there. The growth of the forex market has been spurred by the development of electronic trading networks and the increase in globalization.

    Specifically, the forex market focuses on the trade of currencies by both large investment banks and individuals around the world. All trading is done over-the-counter, which adds to the market's liquidity, allowing trades to be made 24 hours a day. Trading can be done in nearly all currencies, however, a small group known as the 'majors' is used in most trades. These currencies are the U.S. dollar, the euro, the British pound, the Japanese yen, the Swiss franc, the Canadian dollar and the Australian dollar. All currencies are quoted in currency pairs.

    When a trade is made in forex, it has two sides - someone is buying one currency in the pair, while another individual is selling the other. Although the positions traded in forex are often in excess of 100,000 currency units, only a fraction of the total position comes from the investor. The remainder is provided by a broker, which offers the leverage needed to make the trade.

    Traders look to make a profit by betting that a currency's value will either appreciate or depreciate against another currency. For example, assume that you purchase US$100,000 by selling 80,000 euros. In this case, you are betting that the value of the dollar will increase against the euro. If your bet is correct and the value of the dollar increases, you will make a profit. In order to collect this profit, you will have to close your position. To do this, you must sell the US$100,000, in which case you will receive more than 80,000 euros in return.

    Traders are not required to settle their positions on the delivery date, which usually arises two business days after the position is opened. Traders can roll over their positions to the next available delivery date. However, if a trader takes this route, he or she is left open to incurring a charge that can arise depending on his or her position and the difference between the interest rates on the two currencies in the pair.

    To learn more, see A Primer On The Forex Market, Getting Started In Forex and Wading Into The Currency Market.


  • What are the advantages of using a mini forex account for trading?
    A:


    A mini forex trading account involves using a trading lot that is one-tenth the size of the standard lot of 100,000 units. In a mini lot, one pip of a currency pair based in U.S. dollars is equal to $1, compared to $10 for a standard-lot trade. Mini lots are available to trade if you open a mini account with a forex dealer and are a popular choice for those who are just learning how to trade.

    Advantages of a Forex Mini Account
    Mini forex accounts require a relatively small amount of upfront capital to get started. This can be ideal for those looking to learn about trading currencies but who do not want to put much money at risk. In many cases, a mini account can be opened with as little as $250 in starting capital. Even though it is an advantage to open an account with a small amount of upfront capital, it is also important to realize that using leverage could make things much riskier if the currency pair makes a small adverse move. This problem can be reduced by starting with more than the account minimum to make the amount of leverage more manageable. (For related reading, see Forex Leverage: A Double-Edged Sword.)

    Traders with a forex mini account are not limited to only trading one lot at a time. To make an equivalent trade to that of a standard lot, the trader can trade 10 mini lots. By using mini lots instead of standard lots, a trader customize the trade and have greater control of risk. For example, if a trader wants to trade more than 100,000 units (one regular lot), but 200,000 units (two regular lots) is too risky, the trader using the regular account would not be able to trade. However, by using a mini account, a trader could make the trade by trading between 11 and 19 mini lots.

    Retail forex brokers often allow a significant amount of leverage when using mini lots. This minimizes risk on their end by lowering trade amounts. Often forex traders will use mini forex trading to gain the extra leverage available, but still trade in units of 100,000 (10 mini lots.) The greater customization of risk and the larger amounts of leverage available make forex mini accounts advantageous for many retail forex traders. (For more, see Forex Minis Shrink Risk Exposure.)


  • What are the most common currency pairs traded in the forex market?
    A:

    There are many official currencies that are used all over the world, but there only a handful of currencies that are traded actively in the forex market. In currency trading, only the most economically/politically stable and liquid currencies are demanded in sufficient quantities. For example, due to the size and strength of the United States economy, the American dollar is the world's most actively traded currency.

    In general, the eight most traded currencies (in no specific order) are the U.S. dollar (USD), the Canadian dollar (CAD), the euro (EUR), the British pound (GBP), the Swiss franc (CHF), the New Zealand dollar (NZD), the Australian dollar (AUD) and the Japanese yen (JPY).

    Currencies must be traded in pairs. Mathematically, there are 27 different currency pairs that can be derived from those eight currencies alone. However, there are about 18 currency pairs that are conventionally quoted by forex market makers as a result of their overall liquidity. These pairs are:







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




    The total amount of currency trading involving these 18 pairs represents the majority of the trading volume in the FX market. This manageable number of choices makes trading a lot less complicated compared to dealing with equities, which has thousands of possible choices to choose from.

    To learn more about forex, see The Forex Market, The Fundamentals Of Forex Fundamentals andA Primer On The Forex Market.




  • What are the rules for placing stop and limit orders in forex?
    A:

    The high amounts of leverage commonly found in the forex market can offer investors the potential to make big gains, but also to suffer large losses. For this reason, investors should employ an effective trading strategy that includes both stop and limit orders to manage their positions.

    Stop and limit orders in the forex market are essentially used the same way as investors use them in the stock market. A limit order allows an investor to set the minimum or maximum price at which they would like to buy or sell, while a stop order allows an investor to specify the particular price at which they would like to buy or sell.

    An investor with a long position can set a limit order at a price above the current market price to take profit and a stop order below the current market price to attempt to cap the loss on the position. An investor with a short position will set a limit price below the current price as the initial target and also use a stop order above the current price to manage risk.

    There are no rules that regulate how investors can use stop and limit orders to manage their positions. Deciding where to put these control orders is a personal decision because each investor has a different risk tolerance. Some investors may decide that they are willing to incur a 30- or 40-pip loss on their position, while other, more risk averse investors may limit themselves to only a 10-pip loss.

    Although where an investor puts stop and limit orders is not regulated, investors should ensure that they are not too strict with their price limitations. If the price of the orders is too tight, they will be constantly filled due to market volatility. Stop orders should be placed at levels that allow for the price to rebound in a profitable direction while still providing protection from excessive loss. Conversely, limit or take-profit orders should not be placed so far from the current trading price that it represents an unrealistic move in the price of the currency pair.

    To learn more, see The Stop-Loss Order - Make Sure You Use It, Limiting Losses and A Primer On The Forex Market.


  • What causes a recession?
    A:

    The National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales." A recession is also said to be when businesses cease to expand, the GDP diminishes for two consecutive quarters, the rate of unemployment rises and housing prices decline.

    The nature and causes of recessions are simultaneously obvious and uncertain. Recessions can result from a cluster of business errors being realized simultaneously. Firms are forced to reallocate resources, scale back production, limit losses and, sometimes, lay off employees. Those are the clear and visible causes of recessions. It is not clear what causes a general cluster of business errors, why they are suddenly realized and how they can be avoided. Economists disagree about the answers to these questions and several different theories have been offered.

    Many overall factors contribute to an economy's fall into a recession, as we found out during the U.S. financial crisis, but one of the major causes is inflation. Inflation refers to a general rise in the prices of goods and services over a period of time. The higher the rate of inflation, the smaller the percentage of goods and services that can be purchased with the same amount of money as before. Inflation can happen for reasons as varied as increased production costs, higher energy costs and national debt. (For more on this topic, see "All About Inflation.")

    In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. As individuals and businesses curtail expenditures in an effort to trim costs, GDP declines and unemployment rates rise because companies lay off workers to reduce costs. It is these combined factors that cause the economy to fall into a recession.

    Macroeconomic and Microeconomic Components of Recessions

    The standard macroeconomic definition of a recession is two consecutive quarters of negative GDP growth. Private business, which had been in expansion prior to the recession, scales back production and tries to limit exposure to systematic risk. Measurable levels of spending and investment are likely to drop and a natural downward pressure on prices may occur as aggregate demand slumps.

    At the microeconomic level, firms experience declining margins during a recession. When revenue, whether from sales or investment, declines, firms look to cut their least-efficient activities. A firm might stop producing low-margin products or reduce employee compensation. It might also renegotiate with creditors to obtain temporary interest relief. Unfortunately, declining margins often force businesses to fire less productive employees.

    Economists' Takes on Recessions

    American economist Murray Rothbard pointed out that no business or industry makes malinvestments intentionally. When those malinvestments are serious enough, the business loses money and might have to go out of business. Entrepreneurs who tend to avoid losing investments survive in the market. At any time, the majority of entrepreneurs are proven success stories. How, then, is it possible that a huge number of businesses make bad investments around the same time, thus contributing to a recession?

    Rothbard named this quandary "a cluster of entrepreneurial error." He theorized that something must have driven the general business community to make unsustainable investments in the recent past. Once the reality of the situation becomes known, businesses and investors are in a rush to avoid fallout. Subsequent productivity and asset prices drop. The resulting recession lasts until the bad investments are liquidated and resources are reallocated.

    Another view comes from U.K. Economist John Maynard Keynes, who famously suggested that the business and investment community was fickle and prone to bouts of extreme over- and under-confidence. He called the forces that led to recession "animal spirits." This explanation assumes a strong correlation between stock market performance and business productivity, and it also assumes swings in confidence cannot be predicted.

    The Bottom Line

    Every recession is unique, and most economists do not subscribe to a single theory of the causes and prevention of recessions. Most recessions are broadly blamed on demand or supply shocks such as interest rate hikes or periods of high deflation and chronically low interest rates or sharp rises in commodity prices, respectively. These theories tend to look to past recessions to understand the current causes, which does not stand to be indicative of understanding the unique causes of recessions.

    For further reading, see "Investment Portfolio Strategy in a Recession" and "Recession: What Does It Mean to Investors?"


  • What do 'outrights' mean in the context of the FX market?
    A:

    The term outrights is used in the forex (FX) market to describe a type of transaction where two parties agree to buy or sell a given amount of currency at a predetermined rate at some point in the future. This type of transaction is also referred to as a forward outright, an FX forward or a currency forward. A forward outright transaction is mainly used by parties seeking to hedge against adverse currency fluctuations or to stabilize a stream of future cash flows by taking advantage of the current rate.

    For example, let's say a U.S. company known as ZXY imports most of its materials from the U.K. every six months and its executives believe that the value of the domestic currency is going to decrease. If the domestic currency's value does decrease, it will take more U.S. dollars to buy the same amount of materials. In this case, the company could take advantage of a forward outright transaction, allowing the two parties to agree on a certain exchange rate today, and when ZXY needs to purchase materials in six months, it will not be affected by adverse changes in the exchange rate.

    An outright rate differs from the rate used in the spot market because the parties factor in characteristics such as the volatility of the currencies and their mutual opinion of where they think the exchange rate will be in the future. The disadvantage of using a forward outright is that the exchange rate could move in what would have been a favorable direction had the hedge not been implemented. In this case, the investor doesn't stand to gain from favorable changes in the exchange rate because they agreed to pay a predetermined exchange rate irregardless of the rate when the investor makes the purchase.

    For further reading, see "A Primer on the Forex Market," "Getting Started in Forex" and "Top 6 Questions About Currency Trading."


  • What do the terms weak dollar and strong dollar mean?
    A:

    The terms weak dollar and strong dollar are generalizations used in the foreign exchange market to describe the relative value and strength of the U.S. dollar against other currencies. The terms "strong," "weak," "strengthening" and "weakening" are interchangeable for any currency.

    Defining a Strong and Weak U.S. Dollar

    A strong dollar means that the U.S. dollar has risen to a level that is near historically high exchange rates for the other currency relative to the dollar. For example, the exchange rate between the U.S. and Canada has hovered between 0.7292 CAD/USD and 1.0252 CAD/USD, which means that if the current exchange rate is at 0.7400 CAD/USD, the American dollar would be considered weak and the Canadian dollar strong.

    A strong U.S. dollar means that the currency is trading at a historically high level, such as 1.1000 CAD/USD. (For a real-world example, see "Trump Comments Trigger U.S. Dollar, Bond Yield Slide.")

    The terms strengthening and weakening have the same context in that they each refer to the changes in the U.S. dollar over the period of time. A strengthening U.S. dollar means that it now buys more of the other currency than it did before. A weakening U.S. dollar is the opposite – the U.S. dollar has fallen in value compared to the other currency – resulting in fewer U.S dollars being exchanged for the stronger currency.

    For example, USD/NGN (dollar to Nigeria's naira) is quoted at 315.30, which means that $1 USD = 315.30 NGN. If this quote drops to 310.87, the U.S. dollar would be said to have weakened compared to the Nigerian naira, since $1 USD translates to fewer naira than before.

    Why a Strong Dollar Could Be Bad for Investors

    The U.S. dollar hit its highest levels in 13 years shortly after Donald Trump won the presidential election in November 2016, as indicated in the above example. However, since his inauguration, the corresponding dollar index has lost around 9% versus a basket of other currencies. The dollar has experienced significant volatility as investors reacted to President Trump's proposed overhaul to current tax policy – and the expectation of higher interest rates amid the arrival of a new Federal Reserve chairman in the months ahead – with a great deal of skepticism and caution.

    Even though market fluctuations could make you think otherwise, a strong U.S. dollar is not tied to a strong U.S. economy, as many pundits like to state. In fact, the U.S. economy is not as strong as the dollar, at least for the moment. Strength, as noted above, is relative to other currencies where valuations are being reduced in an effort to help fuel growth. In the case of interest rate increases by the Federal Reserve have leveled out at 1.5% at the moment. Additionally, we cannot discount deleveraging playing a role as debts are being paid off, leading to fewer dollars in the system and increasing the value of those dollars.

    U.S. Dollar Impact on Multinational Companies

    A strong U.S. dollar could be bad for large-cap multinationals because it makes American goods more expensive overseas. If the U.S. dollar continues to appreciate, then it could also have a negative long-term impact because those overseas consumers will begin to turn away from American brands. 

    The sectors impacted most by a strong dollar are technology, energy and basic materials, but the large-cap names that will potentially see their earnings take a hit go well beyond these three sectors. Some of the names that have been negatively impacted or might be negatively impacted by a strong U.S. dollar include:

    • General Motors Co. (GM)
    • 3M Company (MMM)
    • Procter & Gamble Co. (PG)
    • Estée Lauder Companies Inc. (EL)
    • International Business Machines Corp. (IBM)
    • Chevron Corp. (CVX)
    • E. I. du Pont de Nemours and Co. (DD)
    • United Technologies Corp. (UTX)
    • Accenture plc (ACN)
    • Oracle Corp. (ORCL)

    Domestic Companies Not Impacted by U.S. Dollar

    On the other end of the spectrum, domestic companies will not be negatively impacted by the U.S. dollar. However, while the domestic economy is often advertised as strong, this is primarily based on the labor market. The labor force participation rate, not just the unemployment number is often the best indicator of labor market strength. (For more, see "The True Unemployment Rate: U6 Versus U3.")

    The truth is that the vast majority of stocks will have a relatively difficult time seeing appreciation over the next year due to a lack of wage growth and sustainable consumer spending. However, if you would like take a long-term stock selection approach without having to worry about a U.S. dollar impact, the following companies may be worth further analysis:

    • Alaska Air Group, Inc. (ALK)
    • Dollar General Corp. (DG)
    • The TJX Companies, Inc. (TJX)
    • CVS Health Corp. (CVS)
    • The Allstate Corp. (ALL)
    • UnitedHealth Group Inc. (UNH)

    The Bottom Line

    The strength or weakness of the U.S. dollar will impact FX traders and, in general, any international currency plays. On a stock selection level, a declining U.S. dollar means it may be prudent to consider staying away from multinationals and looking into companies that only have domestic exposure, as they are less impacted on a relative basis.


  • What does deflation mean to investors?
    A:

    The cause and effect of deflation are complex economic forces, which requires a short introduction to the concept and an explanation of how it affects investors.

    Deflation is a macroeconomic condition where a country experiences lowering prices. This is the opposite of inflation, which is characterized by rising prices. (Note: Deflation is different from disinflation, which is a slowing of inflation.) To many economists, deflation is more serious than inflation because deflation is more difficult to control. Let's take a look at the different effects of deflation.

    Yes, people would presumably be happier if prices were to go down. Everything becomes cheaper, and the money that we have seems to go a little further than before. However, when this effect drags on for too long, companies' profits begin to decline. Economic conditions (such as excess supply) force companies to sell their products for even cheaper and subsequently cut back on production costs, reduce employee wages, lay off workers or even close production facilities. At this point, unemployment will increase, the economy cannot expand and people aren't spending their money because their economic future seems uncertain.

    Equity prices begin to decline as people sell off their investments, which are no longer offering good returns, and bonds temporarily become more attractive. Until the government can find a way to increase consumer and business spending – usually by lowering interest rates to stimulate the economy – equity prices will be negatively impacted.

    Now that you know the effects of deflation, you can imagine why it is considered worse than inflation, because in times of inflation, governments curb spending and encourage saving by increasing interest rates. However, as governments do the opposite to encourage spending during deflation, they cannot lower the nominal interest rates to a negative level, or below zero. Central banks in areas affected by deflation can only move the rate by a certain amount.

    For further reading, see "All About Inflation."


  • What does rollover mean in the context of the forex market?
    A:

    In the forex (FX) market, rollover is the process of extending the settlement date of an open position. In most currency trades, a trader is required to take delivery of the currency two days after the transaction date. However, by rolling over the position – simultaneously closing the existing position at the daily close rate and re-entering at the new opening rate the next trading day – the trader artificially extends the settlement period by one day.

    Often referred to as tomorrow next, rollover is useful in FX because many traders have no intention of taking delivery of the currency they buy; rather, they want to profit from changes in the exchange rates. Since every forex trade involves borrowing one country's currency to buy another, receiving and paying interest is a regular occurrence. At the close of every trading day, a trader who took a long position in a high-yielding currency relative to the currency that they borrowed will receive an amount of interest in their account.

    Conversely, a trader will need to pay interest if the currency they borrowed has a higher interest rate relative to the currency that they purchased. Traders who do not want to collect or pay interest should close out of their positions by 5 P.M. Eastern.

    Note that interest received or paid by a currency trader in the course of these forex trades is regarded by the IRS as ordinary interest income or expense. For tax purposes, the currency trader should keep track of interest received or paid, separate from regular trading gains and losses.

    To learn more, see "A Primer on the Forex Market," "Getting Started in Forex," and "Top 6 Questions About Currency Trading."


  • What economic indicators are most used when forecasting an exchange rate?
    A:

    The economic indicators used to forecast an exchange rate are the same ones used to determine the overall economic health of a country. The gross domestic product (GDP), consumer price index (CPI), producer price index (PPI), employment data and interest rates are all key determining factors of a country’s foreign exchange rates.

    Exchange rates are among the top factors that distinguish the health of a country's economy. Also known as a forex rate, the foreign exchange rate is the value of the currency of one nation in relation to another nation's currency.
    The GDP) of a country is a representation of the dollar value of goods and services that have been produced within that country, generally over the span of one year. The GDP may also be thought of as the basic size of the country's economy. Changes in the GDP reveal changes in economic growth and can directly impact the relative value of a country’s currency. A high GDP reflects larger production rates, an indication of a greater demand for that country's products. An increase in demand for a country's goods and services generally translates into an increased demand for the country's currency.

    The CPI is another important indicator for investors and economists and is a metric for changes in price of a predetermined group of goods and services which are bought by households within a country. The CPI is used to track price changes and reflect inflation rates. A rise in prices on the CPI indicates a weakening in the purchase power of the country's currency. Especially high inflation relative to inflation rates in other countries magnifies the effect of this factor.

    The PPI measures the average change in sale price of all raw goods and services, and it examines these changes from the viewpoint of the producer and not the consumer. The PPI and CPI are obviously interrelated; increased producer costs are most often passed on to consumers.

    Employment data is another indication of a country's exchange rate. Higher employment rates are typically a sign of higher demand for production of the country's goods, so it is therefore a signal that the value of a country's currency is higher. Greater demand for products and services from a country results in an increase in the number of workers required to meet the demand. Higher demand usually means a country is doing more exporting, and more foreign currency is being exchanged in favor of the home country.

    One final indicator widely used to forecast the exchange rate of a country is the interest rate set by its central bank. A country offering higher interest rates is usually more appealing to investors than a country offering relatively lower rates.


  • What happens to the US dollar during a trade deficit?
    During a trade deficit, the U.S. dollar generally weakens. Of course, there are numerous inputs that determine currency movements in addition to balance of payments, including economic growth, interest rates, inflation and government policies. A trade deficit is a negative headwind for the U.S. dollar, but it can still appreciate due to other factors.

    A trade deficit means that the United States is buying more goods and services from abroad than it is selling abroad. Foreign firms end up with U.S. dollars. Typically, they use these U.S. dollars to purchase Treasury securities or other U.S.-based assets, particularly during periods of financial stability and growth.

    If imports continue to exceed exports, the trade deficit continues to worsen leading to more outflows of U.S. dollars. The flow of dollars out of the country leads to weakness for the currency. As the dollar weakens, it makes imports more expensive and exports cheaper, leading to some moderation of the trade balance. As the currency continues to weaken, it makes U.S. dollar-denominated assets cheaper for foreigners.

    The U.S. has run persistent trade deficits since the mid-1980s, but this has not translated into significant dollar weakness as would be expected. The primary reason is the U.S. dollar's status as the world's reserve currency. Dollar demand continues, as it plays a major role in global trade and reserves for central banks all around the world.

    Major economies that issue their own currency, such as the European Union, Japan and England are in a similar space, where they can run persistent trade deficits. Countries that do not have the faith of the investing community are more prone to seeing their currencies depreciate due to trade deficits.


  • What impact does a higher non-farm payroll have on the forex market?
    A:

    Traders are constantly monitoring various economic indicators to identify trends in economic growth. Some of the most watched economic indicators include the Consumer Price Index, housing starts, gross domestic product and the employment report, which contains a variety of data and statistics regarding the employment information of the market.

    The employment report is released on the first Friday of every month by the Bureau of Labor Statistics, providing data covering the previous month. The report contains information on unemployment, job growth and payroll data, among other statistics.

    The most important payroll statistic that is analyzed from the report is the non-farm payroll data, which represents the total number of paid U.S. workers of any business, excluding general government employees, private household employees, employees of nonprofit organizations that provide assistance to individuals, and farm employees. This data is analyzed closely because of its importance in identifying the rate of economic growth and inflation.

    As with other indicators, the difference between the actual non-farm data and expected figures will determine the overall impact on the market. If the non-farm payroll is expanding, this is a good indication that the economy is growing, and vice versa. However, if increases in non-farm payroll occur at a fast rate, this may lead to an increase in inflation. In forex, the level of actual non-farm payroll compared to payroll estimates is taken very seriously. If the actual data comes in lower than economists' estimates, forex traders will usually sell U.S. dollars in anticipation of a weakening currency. The opposite is true when the data is higher than economists' expectations.

    To learn more, see "How to Trade Forex on News Releases," "A Guide to Conference Board Indicators," and "Economic Indicators to Know."