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The foreign exchange market has no central clearinghouse as do the stock market and the commodity futures marketGetting Started The Regulatory Environment The foreign exchange market has no central clearinghouse as do the stock market and the commodity futures market. Nor is it based in any one country; it is a complex, loosely woven worldwide network of banks. These two facts permeate every aspect of currency trading, especially the regulatory environment. It is difficult, if not impossible, to get a firm regulatory grip on such an entity. That cuts both ways. The market is very laissezfaire, but it is also a caveat emptor enterprise. If you wish to trade currencies, you must accept these facts from the beginning. Regulation Today The retail FOREX regulatory picture continues to evolveslowly. Three years ago some broker-dealers proudly advertised they were not NFA members. Curiously one of those was REFCO, which failed soon thereafter. Today all of the major broker-dealers have joined the NFA (National Futures Association) and come under the watchful government eye of the CFTC (Commodity Futures Trading Commission). My first advice to you: Do not trade with an unregistered broker-dealer. Every broker-dealer should have his NFA registration number on the web sites home page. Regulation is seldom proactive; it usually is the result of a crisis. An NFA spokesman confessed to me that their hands were somewhat tied until a crisis provoked additional legislation. The NFA does host a booth at most FOREX trade shows. If you attend one of these, you might want to ask questions or voice your concerns to the people staffing them. They seem to be good listeners and keep close tabs on the pulse of the FOREX marketplace. Broker-dealers register as Futures Commission Merchants (FCMs). Currently, Introducing Brokers (IBs) can be covered by the FCM or register independently. As below, it is likely that IBs will all soon be required to register. Appendix A, How the FOREX Game Is Played, outlines many of the issues all partiesbroker-dealers, traders, and regulatorsare grappling with today. The Commodity Futures Trading Commission (CFTC) In 1974 Congress created the Commodity Futures Trading Commission as the independent agency with the mandate to regulate commodity futures and options markets in the United States. The agency is chartered to protect market participants against manipulation, abusive trade practices, and fraud. Through effective oversight and regulation the CFTC enables the markets to better serve their important function in the nations economy, providing a mechanism for price discovery and a means of offsetting price risk. The CFTC also seeks to protect customers by requiring: (1) that registrants disclose market risks and past performance to prospective customers (in the case of money managers and advisors); (2) that customer funds be kept in accounts separate (segregated funds) from their own use; and (3) that customer accounts be adjusted to reflect the current market value of their investments at the close of each trading day (clearing). Futures accounts are technically safer than securities accounts because brokers must show a zero-zero balance sheet at the end of each trading session. National Futures Association The CFTC was originally created under so-called Sunshine Laws meaning that its continued existence would be evaluated vis--vis its effectiveness. As the futures industry exploded in the late 1970s, not only was its charter renewed but a separate quasi-private self-regulatory agency was created to implement the laws, rules, and regulations. Thus in 1982 was born the National Futures Association (NFA). The NFA is the CFTCs face to the public and directs the regulatory and registration actions of the CFTC into the marketplace. The NFA stipulates that members cannot transact business with nonmembers. So, for example, if your FOREX broker/dealer is an NFA member, it is not allowed to do business with nonmember money mangers (Commodity Trading Advisors or CTAs). Commodity Futures Modernization Act of 2000 This was the first act by the CFTC pertaining to the then-emerging retail FOREX business. Beginning in the 1980s cross-border capital movements accelerated with the advent of computers, technology, and the Internet extending market continuum through Asian, European, and American time zones. Transactions in foreign exchange rocketed from about $70 billion a day in the 1980s to more than $2 trillion a day two decades later. The Patriot Act A principal feature of the ubiquitous Patriot Act is the desire to limit money laundering so that large transactions might be followed, theoretically ensuring funds are not headed to finance terrorist activities. It is obvious such tracking will affect foreign exchange markets. You will see reference to the Patriot Act on broker forms when you open an account. The CFTC Reauthorization Act of 2005 The most critical legislation of interest to U.S. traders is the CFTC Reauthorization Act of 2005; it specifically addresses retail FOREX. See Appendix B, Section 101(a)(B)Agreements, Contracts, and Transactions in Retail Foreign Currency. The primary thrust of the Reauthorization Act and legislation currently pending is to require retail brokers to meet minimum capital requirements. The new minimum will apparently be $5,000,000. If so, many small firms will either close, be absorbed, or face mandated euthanasia. At the time of this writing this is, in fact, already taking place. The NFA is also enacting a Know Thy Customer rule for FCMs. This will require them to undertake a more proactive due diligence of prospective clients and their suitability for currency trading. One effect of this will probably be eliminating account funding options by PayPal and other electronic transfers except for bank wires. Traders may wish to periodically check FOREX broker-dealer financials here: http://www.cftc.gov/files/tm/fcm/tmfcmdata0704.pdf. Retail FOREX seems to be following a path parallel to retail futures in the 1970s and 1980s. If so, the next step will be to require Introducing Brokers (IBs) to either register or themselves meet some minimum capital requirements. Beyond that, expect mergers between the majors within the next two or three years as competition, smaller profit margins, and lower growth rates loom. Similar slow-but-sure regulation of retail FOREX is occurring in other countries. Brokers not domiciled in the United States also should register with the NFA if they desire to prospect and accept accounts from U.S. citizens. The Financial Markets Association (ACI) has suggested international foreign exchange regulatory standards. ACIs model code currently has regulatory standing in Australia, Austria, Canada, Cyprus, Hong Kong, Malaysia, Malta, Mauritius, the Philippines, Slovenia, and Switzerland. Countries with specific agencies regulating FOREX: United Kingdom Financial Services Authority (FSA), AustraliaAustralian Securities and Investment Commission (ASIC), SwitzerlandRequires registration as a Financial Intermediary under Swiss Federal Law, CanadaInvestment Canada, Federal Competition Bureau. Summary The FOREX forums are a good place to find updated regulatory information. Both the CFTC web site, www.cftc.gov and the NFA, www.nfa.futures.org web site are worth checking on a monthly basis. No central clearing exchange means regulation in FOREX evolves slowly and will never be as strong as it is in the securities or futures industry. Caveat emptor. The trend is toward more regulation of cash/spot currency markets. Traders should watch the actions of the Commodity Futures Trading Commission (CFTC) and its quasi-independent administration arm, the National Futures Association (NFA). Do not take regulation as an excuse for not doing your own homework! The FOREX Lexicon As in any worthwhile endeavor, each industry tends to create its own unique lingo. The FOREX market is no different. You, the novice trader, must thoroughly comprehend certain terms before making your first trade. As your eighth-grade English teacher taught you in vocabulary classto use them is to know them. Currency Pairs Every FOREX trade involves the simultaneous buying of one currency and the selling of another currency. These two currencies are always referred to as the currency pair in a trade. Major and Minor Currencies The seven most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, and AUD) are called the major currencies. All other currencies are referred to as minor currencies. The most frequently traded minors are the New Zealand Dollar (NZD), the South African Rand (ZAR), and the Singapore Dollar (SGD). After that, the frequency is difficult to ascertain because of perpetually changing trade agreements in the international arena. Cross Currency A cross currency is any pair in which neither currency is the U.S. Dollar. These pairs may exhibit erratic price behavior since the trader has, in effect, initiated two USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. The three most frequently traded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY. Exotic Currency An exotic is a currency pair in which one currency is the USD and the other is a currency from a smaller country such as the Polish Zloty. There are approximately 25 exotics that can be traded by the retail FOREX participant. Base Currency The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215. In the FOREX markets, the U.S. Dollar is normally considered the base currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The primary exceptions to this rule are the British Pound, the Euro, and the Australian Dollar. Quote Currency The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency. Pips A pip is the smallest unit of price for any foreign currency. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit, that is, EUR/USD equals 1.2812. In this instance, a single pip equals the smallest change in the fourth decimal place, that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equals 1?100 of a cent. One notable exception is the USD/JPY pair where a pip equals $0.01 (one U.S. Dollar equals approximately 107.19 Japanese Yen). Pips are sometimes called points. Just as a pip is the smallest price movement (the y-axis), a tick is the smallest interval of time (the x-axis) that occurs between two trades. When trading the most active currency pairs (such as EUR/USD or USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second. When trading a low-activity minor cross pair (such as the Mexican Peso and the Singapore Dollar), a tick may only occur once every two or three hours. Ticks, therefore, do not occur at uniform intervals of time. Fortunately, most historical data vendors will group sequences of streaming data and calculate the open, high, low, and close over regular time intervals (1-minute, 5-minute, 30-minute, 1-hour, daily, and so forth). See Figure 5.1. Margin When an investor opens a new margin account with a FOREX broker, he or she must deposit a minimum amount of monies with that broker. This minimum varies from broker to broker and can be as low as $100.00 to as high as $100,000.00. Each time the trader executes a new trade, a certain percentage of the account balance in the margin account will be earmarked as the initial margin requirement for the new trade based upon the underlying currency pair, its current price, and the number of units traded (called a lot). The lot size always refers to the base currency. An even lot is usually a quantity of 100,000 units, but most brokers permit investors to trade in odd lots (fractions of 100,000 units). Leverage Leverage is the ratio of the amount used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a security with a comparatively small amount of capital. Leveraging varies dramatically with different brokers, ranging from 10:1 to 100:1. Leverage is frequently referred to as gearing. The formula for calculating leverage is: Leverage = 100 /Margin Percent Bid Price The bid is the price at which the market is prepared to buy a specific currency pair in the FOREX market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation. For example, in the quote USD/CHF 1.4527/32, the bid price is 1.4527; meaning you can sell one U.S. Dollar for 1.4527 Swiss Francs. Ask Price The ask is the price at which the market is prepared to sell a specific currency pair in the FOREX market. At this price, the trader can buy the base currency. It is shown on the right side of the quotation. For example, in the quote USD/CHF 1.4527/32, the ask price is 1.4532; meaning you can buy one U.S. Dollar for 1.4532 Swiss Francs. The ask price is also called the offer price. Bid/Ask Spread The spread is the difference between the bid and ask price. The big figure quote is the dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be 117.30/117.35, but would be quoted verbally without the first three digits as 30/35. Quote Convention Exchange rates in the FOREX market are expressed using the following format: Base Currency /Quote Currency Bid/Ask TABLE 5.1 Examples of Quote Convention EUR/USD1.2604/07GBP/USD1.5089/94CHF/JPY84.40/45 Normally only the final two digits of the bid price are shown. If the ask price is more than 100 pips above the bid price, then three digits will be displayed to the right of the slash mark (that is, EUR/CZK 32.5420/780). This only occurs when the quote currency is a very weak monetary unit. Transaction Cost The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. In the case of the EUR/USD rate in Table 5.1, the transaction cost is three pips. The formula for calculating the transaction cost is: Transaction Cost = Ask Price - Bid Price Rollover Rollover is the process whereby the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies. The Traders Nemesis All traders fear the dreaded margin call. This occurs when the broker notifies the trader that his or her margin deposits have fallen below the required minimum level because an open position has moved against the trader. Trading on margin can be a profitable investment strategy, but it is important that you take the time to understand the risks. You should make sure you fully understand how your margin account works. Be sure to read the margin agreement between you and your clearing firm. Talk to your account representative if you have any questions. The positions in your account could be partially or totally liquidated should the available margin in your account fall below a predetermined threshold. You may not receive a margin call before your positions are liquidated. Margin calls can be effectively avoided by monitoring your account balance on a very regular basis and by utilizing stop-loss orders (discussed later) on every open position to limit risk. For ease of use, most online trading platforms automatically calculate the profit and loss of a traders open positions. When you open an online FOREX account, the trading platform will have preset leverage options. These typically run from 10:1 to 200:1. Start low and work your way up as you meet with trading success. You will not be able to enter a trade that exceeds the set leverage value. For more, see Chapter 15, Money Management Made Simple. Margin Calls Nearly all FOREX brokers monitor your account balance continuously. If your balance falls below four percent of the open margin requirement, they will issue the first margin call warning, usually by an online popup message on the screen and/or an e-mail notification. If your account balance drops below three percent of the margin requirement for your open positions, they will issue a second margin warning. At two percent, they will liquidate all your open trades and notify you of your current account balance. These percentages may vary from broker to broker. You may not even be able to execute a trade that exceeds certain capital and risk parameters. Summary Trading currencies on margin lets you increase your buying power. If you have $2,000 cash in a margin account that allows 100:1 leverage, you could purchase up to $200,000 worth of currency because you only have to post 1 percent of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power. With more buying power, you can increase your total return on investment with less cash outlay. To be sure, trading on margin magnifies your profits and your losses. A detailed description on how to calculate profit and loss of leveraged trades occurs in Chapter 6, The Calculating Trader. |
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