Intermediate Checkpoint

Commander in Pips: Ok, son, I think that now is the time when I will ask some questions and you will have to answer.

Pipruit: Well, Sir maybe we should study a bit more. I’m not sure that I’m ready to take a test yet.

Commander in Pips: Don’t worry, pal. This will just be shallow checkpoint that is based on a previous chapter – a single chapter. If you’ve listened carefully, you will not have any problem at all.

Pipruit: If you are saying it like that… I have nothing more than just to believe you. But I have to warn you, that I’ve skipped all the classes at McConnell-Brue’s Economics Course, so I’m absolutely flat with it.

Commander in Pips: We will touch only simplest things currently. Detailed investigation of Fundamental analysis we will do later.

Pipruit: Ok, let’s try it then.

Commander in Pips: Put your thinking cap on and get ready.

Task #1

Let’s assume that you’ve investigated the economies of the US and the EU and come to the conclusion that the US economy will be stronger in nearest future compared to the EU economy. For simplicity we also assume that economy growth coincides with currency value growth. What kind of trade should you take with EUR/USD pair?

Pipruit: Let’s see. We’ve estimated that EUR is a base currency in EUR/USD pair. It means that whatever I will do (Buy or Sell) I will do this with the EUR, because the base currency determines the trade. According to your conditions, logically, I should wish to Buy USD, because, as you’ve said, the US economy will outperform the economy, so the USD will rise relatively to the EUR. But I can’t buy USD directly, because we trade the EUR/USD pair and I can buy or sell only EUR for USD. Hence, I have to sell EUR for USD…

If the USD value will increase relative to the EUR, then the EUR/USD ratio will decline – consequently, I should Sell EUR/USD.

Commander in Pips: Brilliant!

Now let me rephrase a bit previous task. Say, you expect that EU economy will be weaker relative to the US economy. What should you do in this case?

Pipruit: Ok, then EU economy will underperform compared to the US economy; hence the EUR will perform weaker relative to the USD… Wait a minute – this is the same condition, but from another point of view. It’s much easier to analyze, because conditions are based on Base currency. EUR/USD will decline – the answer is the same - I should Sell EUR/USD.

Commander in Pips: Right again. I just want to show you, that reducing of conditions to base currency makes analysis easier, than from perspective of quote currency. But this is important only in the beginning of your FOREX training. Soon, you will be able to do this off the top of your head.

Pipruit: I think I’ve got it, even after such easy example. Indeed, if you expect that some currency will outperform, hence the counter currency will underperform. And it’s very simple to decide what to do with the particular pair.

Commander in Pips: Ok, if you’re so smart boy, here is another task for you:

Task #2

Let’s imagine that the Bank of Japan (BoJ) investigates the possibility for currency intervention, because the USD/JPY rate is too low. And this is unwelcome situation for domestic producers.

- What does long-term gradual reducing of the USD/JPY rate means in terms of Japanese Yen?

- What should BoJ undertake during possible intervention to partially negate the USD/JPY rate decreasing?

- What sort of position should you open due to all these circumstances to get profit from the intervention?

Pipruit: Wow, wow, Commander! Maybe I’m a smart guy, as you’ve said, but I’m definitely not a tough guy, at least not yet in terms of FOREX.

Commander in Pips: This task is simpler than you think. Just read conditions carefully…

Pipruit: Ok, as you wish, Your Highness. Let’s see…

1. “Bank of Japan (BoJ) investigates the possibility for currency intervention, because the USD/JPY rate is too low” – obviously, due to this condition, BoJ intends to raise the USD/JPY rate with a possible intervention.

2. “What does long-term gradual reducing of the USD/JPY rate means in terms of Japanese Yen?” Well, as with previous task with EUR, it means that either USD underperforms the JPY or the JPY outperforms the USD – anyway, the JPY performs better compared to the USD and the “yen to dollar” rate rises.

3. “What should BoJ undertake during possible intervention to partially negate the USD/JPY rate decreasing?” Hm, I suppose that to negate a decreasing, or stop it for some time, it should initiate timely increasing of the USD/JPY rate. It means that somehow it should weaken the JPY relative to the USD. In this case, the JPY rate will decrease compared to the USD, hence the USD/JPY ratio will increase. Let’s see – in this pair the USD is the base currency, so USD determines the direction of the rate and any transaction, and it should rise…Ok, I think I’ve got it – the BoJ should buy significant amounts of USD for JPY (other words Sell JPY).

4. “What sort of position should you open due all these circumstances?” – Well, now it looks simple. I should Buy USD/JPY.

Commander in Pips: See, it’s not so awful when you break it down. Remember, fear hath a hundred eyes!

Your banner here

Pipruit: Yeah, you’re absolutely right. So, may be you have some additional tasks?

Commander in Pips: Oh, you’d like that ha? You’ll definitely get more, let’s just remind you of some items about margin trading before that and then we will continue with riddles…

Some talk about the leverage

As you understand – the currency trades in lots, just like an M&M’s candies – you can’t buy just single piece, only 1 pack or more. So the same is with currencies – you can trade pairs in lots. What is a standard lot by the way?

Pipruit: 100 000 units of base currency.

Commander in Pips: That’s right. Also, as we already know there are micro lots – 1 000 units and mini lots – 10 000 units exist. Furthermore, some brokers let trade to their customers with any lot that they want. If you love your grandma and her favorite year was 1958 then you even can trade with 1958 units – no problem. But when the number of units (i.e. lot size) is too small, then the results of trading are negligible and they are not worth that hard work that you will have to do to earn them. As you understand hard work absolutely does not depend on the lot size. It will be the same amount of work to analyze the marker and then to place a trade for 1 unit of currency or for 100 000 units.

Also we’ve already talked about leverage that could be provided by FX broker that allows you to trade with much smaller amount of cash. This type of transaction is called margin trading. Let’s see if you remember anything on this topic that we’ve talked about before… Here is the next riddle:

Task #3

Let’s assume that your FX broker allows to trade not less than with one mini lot (10 000 units) and provide their clients with 1:50 leverage (2% margin). How much cash in USD do you have to deposit in your trading account to open a trade of 1 mini lot, say, on the GBP/USD, if the rate is 1.6200? How much will it be in terms of GBP?

Pipruit: It looks simple – 1.62*10 000/50 = $324. In terms of GBP it will be – 324/1.62 = 200 GBP

Commander in Pips: That’s right. See – you can control a position of $16 200 with just under $350. This is a positive side to margin trading. Just remember that margin trading also has a negative side. We’ll get back to that later.

Here is the last task for today…

Task #4

Assume that tomorrow will be the FOMC meeting and you anticipate the Fed Fund rate increasing more than is expected by the market, or that some commentaries from Chairman that will be supportive for the USD. Whatever the case, you expect the USD grow compared to other currencies. Here are the questions:

1. What position should you take in USD/CHF pair?

2. How much cash should you have on deposit in USD terms if the current USD/CHF ratio is 1.13 in order to trade 0.1 of standard lot with 1:20 leverage (or 5% margin that is the same)?

3. What will the result be on your account, if the USD/CHF rate will increase by 0.01? What should it to do by the way, to behave in line with your expectations?

Pipruit: Commander you’re becoming more harsh just before my very eyes…

Commander in Pips: Come on, you can do it! This riddle has some moments that demand brain work, not just knowledge…

Pipruit: You’ve becalmed me much with this statement, Sir...

1. “What position should you take in USD/CHF pair?” This is the easiest question. I expect an increasing of value of USD that is a Base currency. It means that it determines the direction of ratio – USD outperforms - USD/CHF rises, USD underperforms – USD/CHF falls, hence I should buy USD/CHF.

2. “How much cash should you have on deposit in USD terms if the current USD/CHF ratio is 1.13 in order to trade 0.1 of standard lot with 1:20 leverage (or 5% margin that is the same)?” I see a trick question here – USD is the base currency in this pair, so I do not need to know ratio to calculate the deposit in terms of base currency. All that I have to know in this case is a leverage ratio and lot size, because in any trade the amount of base currency that is involved in the transaction is equal to lot size, i.e. the number of units and does not depend on any ratio. The ratio, in turn, shows the amount of quote currency for 1 unit of base currency and it’s absolutely necessary to know, if you have asked me to calculate deposit in terms of CHF. So my answer is 0.1*100 000/20 = 500 USD. In terms of CHF – 1.13*0.1*100 000/20 = 565 CHF.

3. “What will the result be on your account, if the USD/CHF rate will increase by 0.01? What should it to do by the way, to behave in line with your expectations?” Let me answer on the second question first. Obviously USD/CHF should show growth – we’ve talked about it in the first question already. It’s not so simple with the calculations – I will try to do them in table sheet:

Trade consequence	USD/CHF rate	USD	CHF
1. Place (lock) margin (deposit) 500 USD		500 locked
2. BUY 0.1 lot USD/CHF (Buy 10 000 USD for 11 300 CHF).	1.13	+10 000	-11 300
3. Rate change to 1.14	1.14	-	-
4. Close position – SELL 0.1 Lot USD/CHF (Sell 10 000 USD for 11 400 CHF)	1.14	- 10 000	+ 11 400
5. Returning (unlocking) margin of 500 USD		500 unlocked
Total	+0.01	0	+ 100 CHF

Pipruit: But, Commander, what should I do with these 100 Swiss francs? I do not need them. I need bucks…

Commander in Pips: Here is the trap in this task. You’ve done well. Tell me, if USD/CHF rate 1.14 at moment of closing your initial position, how many USD you will get for 100 CHF?

Pipruit: 100CHF/1.14=$87.72

Commander in Pips: Fine, precisely this amount of USD will be added to your available account balance when close your trade. The point is that your FX broker will convert profit or loss into the currency that your initial deposit was using. And this will be done simultaneously and at the same rate with the position closing. It means that when you just click “Sell” USD/CHF button at 1.14 in our example, you get profit 100 CHF and broker converts that into USD, if your initial trading deposit in USD. If it was created in EUR – broker coverts it to EUR, etc. The same thing if you will get, 100 JPY profit, for example. They also will be converted in the currency of your initial deposit. Later I’ll give you another example.

Pipruit: Cool! This is much comfortable than accumulate profits on in different amounts of different currencies.

Commander in Pips: Exactly. And this was done particularly for this purpose. Now, take a look at table below. This is typical information about trades that has not been closed yet, i.e. open trades. What can you tell me about it?

Pipruit: Let’s see. I think that “Order” and “Time” are number of order and time of opening the trade, “Type” – Buy or Sell, its obvious. “Size” – is a number of lots, unfortunately I do not see, what is the lot value, but, probably 1 lot is 100 000 units of base currency, so current position is for 10 000 units. First “Price” is 1.29469 – looks like this is initial price that trader had bought at, “S/L” and “T/P” – I do not know what they are… Ok, then, second “Price” – this is current price 1.29771, because, as you’ve said, trade has not been closed yet. “Commiss”…? Oh, I think this is “Commissions” and they are equal to zero. Then “Swap” and “Profit”. Profit is obvious thing, by the way – (1.29771-1.29469)* 10 000 = $30.20, so I was right about lot size!

“Margin” on the second row shows 25.89$. Hm… Interesting, what the leverage value is…I will calculate it, if you don’t mind - let’s, see position value is 0.1*100 000*1.29469 = $12 946.9. So leverage is $12 946.90/$25.89 = 500! That’s huge! 500:1!

But what does swap mean? Don’t you want to tell me that this is SWAP trade, Commander? Also, take a look – total profit is different from final profit precisely at the value of the swap – $0.07.

Commander in Pips: This is not the SWAP trade. You’ve done well, especially with noticing that total profit is different from position profit for swap value. So, here is what “Swap” means:

Swap or Rollover value.

Here we will talk not about Swap trades and Swap markets, but about swap value that is applicable to spot FOREX. Don’t confuse these two absolutely different terms!

Sometimes, this swap also called as Rollover value. Swap can appear only when you rollover your position, that you’ve previously opened through trading day close time. That’s why it is called Rollover. For example, suppose that your FX broker uses 00:00 time as a daily closing time (or 5:00 PM EST that is common). If, for example you have opened a position during today’s trading session and decided not to close it and hold at least till the next day – in other words rolling it over to the next day through close time. Now your position has not been closed before 00:00 time. In this case you will get a Swap value that could be negative or positive. The value of the swap (as a rule, but not always) will depend from overnight interest rates on currencies that you have traded as a pair. Let’s look at our table with EUR/USD. This swap depends on EUR rate and USD rate.

Pipruit: But why does swap appears at all?

Commander in Pips: Swap appears, because the major part of participants in the forex market do not intend to take a real delivery of foreign currency. When, for example, you Buy 10 000 EUR/USD at 1.35 – you do not have 13 500 USD to deliver. So, it turns out that your counterparty on this trade has to credit you with this amount of USD until you will close your trade, and you have to pay interest due to this credit. But the counterparty, in turn, does not have 10 000 EUR, or even if he/she does, he/she does not intend to deliver it also. This turns out that now you lend him with 10 000 EUR and he/she, in turn, has to pay interest due to this credit. As you understand, interest rates on USD and on EUR are different, and amount of EUR and USD is different also (10 000 EUR vs. 13 500USD), and it leads to the fact that those who have to pay more will have a negative swap, and the counterparty will have the same positive swap. But the general rule here as follows:

If you Buy (i.e. Lend to counterparty) currency with higher interest rate and Sell (i.e. borrow from counterparty) currency with lower interest rate, then the interest rate differential will be positive and you will get positive swap.

And vice versa –If you Buy (i.e. Lend to counterparty) currency with lower interest rate and Sell (i.e. borrow from counterparty) currency with higher interest rate, then the interest rate differential will be negative and you will get negative swap.

Pipruit: And what kind of interest rates usually used in swap calculation?

Commander in Pips: Hah, this is the most tricky moment son. Well, most part of brokers use overnight Central Banks rates. For USD this is Fed Fund rate, for EUR – ECB overnight rate, etc. In other words, the rate was set by a National Central Bank. Also the broker could be using such rates as overnight LIBOR, EURIBOR and some others. Here are some benchmark interest rates – set by National Central Banks (As of January 2011):

Country	Interest Rate
United States	0.25%
Euro zone	1.00%
United Kingdom	0.50%
Japan	0.10%
Canada	1.00%
Australia	4.75%
New Zealand	3.00%
Switzerland	0.25%

But, some FX Brokers, especially those who offer to trade on micro accounts can apply fixed swap value for position rollover. And it could not depend on whether it Long or Short, and whether it EUR/JPY or AUD/GBP… Just fixed swap value – usually it will be negative for any rollover of any position and, in fact, this is a hidden commission for position rollover. Other brokers tilt the balance. If positive swap on one lot of a pair is $0.10, then negative swap could be $0.15 or much more.

Pipruit: What then should I do?

Commander in Pips: The answer is simple – you should investigate a Brokers swap procedure with careful scrutiny. Ask them about rollover procedure, interest rates that are used for swap calculation etc. The second way - is just do not rollover your positions, close them during the current trading session. But don’t be afraid too much. In fact, the value of swap is usually very small relatively to profit/loss on your position. If you do not intend to hold it 10 years of course.

Later we will return to this topic, because you can use the rate differential in your favor.