Forex Preliminaries

Forex is a global and decentralized market for trading currencies. It is continuously operational except weekends. The value of exchange rates are determined based on market supply and demand. Supply and demand are further determined by political conditions, market psychology and a variety of fundamental economic factors.

New data is generated with every transaction in the Forex market. A transaction in the Forex market can take place with the meeting of the buyer and the seller at the same price point. This meeting is a non-zero-sum game [7], due to the presence of a market maker which provides the Forex service under transaction costs such as spreads and swaps. With the collection of the transactions in a given period of time, a summarizing set of data –which is called a bar- is produced. A bar in a time frame contains opening, closing, highest and lowest prices for the given time interval.

These are the prices that traders value the most in an interval and are also called as raw price data.

With the use of leverage, profits and losses can be multiplied. Leverages generally result in borrowing costs (swaps). The margin between asking and bidding price is called the spread and is generally very small to allow traders to create medium frequency applications with lower profit margins. For a trading algorithm to be profitable, the sum of profits collected by the algorithm should be higher than sum of losses, borrowing costs and transaction costs.

In this section we provide definitions about concepts and terms commonly used in Forex environment. Detailed definitions of these concepts can be found in [8].

Definition 13 – The first currency in a currency pair is called the base currency. In EUR/USD pair, EUR is the base currency.

13

Definition 14 – From Forex trader’s perspective currency strength expresses the future value of currency and is an indicator of many factors such as the country’s economic parameters and central bank interest rates. A currency’s strength can be calculated against a set of other currencies or commodities.

Definition 15 – Leverage is the use of a financial instrument through borrowed capital. It allows a trader to multiply the potential return of an investment. The borrowed capital is called margin and provided to the trader by the broker firm that operates the investment. A leverage of 1:10 indicates that whenever trader opens a position of volume 1, a transaction with volume 10 is initiated by the broker firm.

Earnings and losses are reflected 10 folds to the account if the leverage is 1:10.

Definition 16 – “Being long” or “going long” on a currency pair means buying the base currency in the pair against the quote currency.

Definition 17 – Margin is the borrowed capital that is provided to a trader using leverage by his broker. It allows the trader to open bigger positions than his account balance. A broker will place rules in place to protect firm’s borrowed money such as a margin call –which limits the losses of a trader in a leveraged position.

Definition 18 – Pip is the smallest amount of change that can take place in a currency’s value. Historically most major currency pairs were priced to four decimal points, hence a pip is valued at 0.0001 of such a currency.

Definition 19 – Since the advancement of the Forex market and an increase in the account leverages, many major currency pairs are priced to five decimal points. The fifth decimal point is 1/10th of a pip and is called a pipette.

Definition 20 – The second currency in a currency pair is called the quote currency.

In EUR/USD pair, USD is the quote currency.

Definition 21 – “Being short” or “going short” on a currency pair means buying the quote currency in the pair against the base currency.

14

Definition 22 – Forex market is a settlement market in which buyers and sellers name their own price. Buyer’s price is the lower price and seller’s price is the higher price. Buyer’s price is also called “Bid” and seller’s price is called “Ask”. The difference between Bid and Ask prices is called spread. In a highly traded currency, the spread is lower. A lower spread would allow the trader to turn in profits in smaller price movements. Spreads can vary due to market volatility and liquidity. In this paper a fixed spread is assumed for all currencies at all times.

Definition 23 – A stop loss is an open position parameter for a Forex trader which allows a predefined amount of pips to be lost in an open position before the position is closed. The parameter allows the trader to accept losses and move on. Since Forex market is highly active and highly leveraged, without a stop loss traders can lose entire accounts in minutes.

Definition 24 – In the Forex market, the term swap refers to an interest rate swap. It is a way for Forex dealers to limit their exposure to fluctuations of interest rates on base and quote currencies. When a base currency with a higher interest rate is longed against a quote currency with a lower interest rate, swap would be positive. In the opposite case swap would be negative. In cases where interest rates are similar, long swap could be zero and short swap could be negative. In some more special cases where interest rates are similar and close to zero, both swaps could be negative.

Swaps are commonly determined by the Forex brokers based on London Interbank Offered Rate (LIBOR).

Definition 25 – A take profit is an open position parameter for a Forex trader which allows a predefined amount of pips to be won in an open position before the position is closed. The parameter allows the trader to cash-in the virtual earnings in the position before the market price changes.

Definition 26 – There are two main approaches to analyze a currency: fundamental analysis and technical analysis. Fundamental analysis analyzes the economic fundamentals regarding a currency such as economic growth or interest rates.

Technical analysis is the study of market price itself. Technical analysis assumes that

15

all the fundamental factors are priced-in the market price and additional information regarding supply and demand can be deducted from the market price action.

Definition 27 – A technical indicator is a metric derived from historical price data to determine future price or direction of a currency. Technical indicators are based on technical analysis and Dow Theory and are mathematical formulae.

Definition 28 – Technical indicators are mathematical formulae and usually provide a number as output. How that number will be interpreted depends upon the trader.

Different traders have different levels and numbers that they watch. A technical indicator signal is an additional set of rules and formulas that turn current or past values of a technical indicator into a trend determination method as simple as “Buy”

or “Sell”.