Market Terminology

Commonly Used Terms

Spot: Spot means the contract is based on an instantaneous price, and the settlement date is two business days forward.

Value Spot:

Refers to the settlement value upon two business days. This settlement

date is always used in the interbank cash market unless otherwise

requested by the client.

Long Position: Buying a currency

in the hope of the currency appreciating in value against another. A

trader who has bought GBP100,000 against the USD is long the GBP versus the USD.

Short Position:

Selling a currency in the hope that a currency will depreciate in value

against another and can be bought back at a lower price. A trader who

has sold GBP100,000 against the USD is short the GBP versus the USD.

Spread:

The difference between buy and sell rates. A trader who wants to

speculate in 100,000 Euros against the USD position is given a quote of

1.15 05/8. The spread in this case is 3 points. Thus, you could buy at

1.1508 or sell at 1.1505.

Bid/Offer: The bid is defined

as the rate a price maker is willing to buy the currency. The offer is

defined as the rate a price maker is willing to sell a currency. For

example, if the USD against the JPY is quoted at 108.80/85, a trader is

able to buy USD at the offer of 108.85, or sell at a bid of 108.80. The

market maker gives you a rate she is willing to buy or sell a currency

pair.

Square: A trader is square when they have no

positions open. You square a position by taking an opposite position in

the currency you bought or sold to realise a profit or loss.

Financing:

After spot value, you earn interest in the currency you bought and

simultaneously pay out interest in the currency you sold. This is also

known as having a financing cost or benefit, and can work for or against

you, depending on the interest rate levels of the respective countries.

This is not something you should use to determine whether or not to

buy/sell a currency. The levels are the most important factor. But it is

something that you should be aware of, especially if you are planning

on holding a currency for an extended period of time (for, say, 30 days

and beyond).

Order Types and Examples

Market Order

A

market order is an order to buy or sell at the current market price. A

trader specifies the currency pair and the deal size, and is given a

two-way price (Bid and Ask price) to trade on.

Example of a Market Order

GBP/USD is currently trading at a price of 1.9500/03. If you believe the GBP will appreciate in value against the USD, you can buy at 1.9500. Conversely, if you believe the GBP will depreciate in value against the USD, you can sell at 1.9503.

Limit Order

A

limit order is an order placed to buy or sell at a certain price. A

limit order allows you to predetermine a price at which you want to sell

above the current price or buy at a level below. This means you can

predefine the level you want to take a profit, or open a trade at a more

favourable rate than the current price of a currency pair without

constantly having to watch the markets.

Example of a Limit Order

You have bought  100,000 GBP/USD at a price of 1.9500. You believe the GBP will strengthen against the USD. You place a GTC (Good Till Cancel) ‘limit order’ to sell 100,000 GBP/USD at 1.9590.

Stop Loss Order

 Stop

loss orders can be used to limit your trading risk and are an essential

part of disciplined trading. Using stops means you are automatically

taken out of a position if the market moves against you, effectively

limiting your loss. Stop losses can also be used to lock in profit. As

the market moves in your favour, you can move your stop order up with

the prevailing price, helping you to lock in profit if the market

suddenly moves against you. This is known as a trailing stop.

Example of a Stop Loss Order

You have bought 100,000 GBP/USD at a price of 1.9500. You believe that the GBP

will strengthen against the USD. However, you want to limit your losses

and place a GTC stop loss order to sell 100,000 GBP/USD at 1.9470, thus

limiting your losses if the GBP/USD falls to 1.9470 or below.

Spot Transactions

Spot

currency transactions account for approximately one-third of the

average daily turnover volume in the Forex market, or $1.33 trillion of

the $4 trillion total daily turnover. Spot transactions mean the

contract is based on an instantaneous price and the settlement date is

two business days forward.

Foreign Exchange Swaps

Currency

swaps transactions account for approximately one-half of the average

daily turnover volume in the FX market, or $2 trillion of the $4

trillion total daily turnover. This is a currency transaction which

involves the actual exchange of two currencies (the principal amount

only) on a specific date at a rate agreed at the time of the conclusion

of the contract (termed the short leg), at a date further in the future

at a rate agreed at the time of the contract (termed the long leg).

Outright Forwards

Currency

forwards transactions account for roughly one-sixth of the average

daily turnover volume in the FX market, or $667 billion of the $4

trillion total daily turnover. This is a currency transaction involving

the rate at which a foreign exchange contract is struck today for

settlement at a specified future date.

Financing Costs

What is Finance?

Sometimes

called ‘spot positions’, daily positions that are rolled over will

incur financing costs or benefits based upon the interest rate

differential between the two applicable currencies.

For example, if you have a long GBP/USD position and interest rates are higher in GBP

than in USD, then you receive interest if you hold the position

overnight. This is because you are holding the higher yielding currency.

However, if the USD interest rate is higher than the GBP, then the interest rate differential will cause you to be charged interest if you hold the position overnight.

Financing Example: How to Calculate the Finance Rollover Rate

The GBP/USD is quoted at ‘1.9500/03’ and the current interest rates in the US and UK are as follows:

US: 2.00%*
UK: 5.00%*

You buy GBP100,000 @ 1.9503 and wish to hold this position overnight.

The interest rate differential between the currency you are buying (GBP) and the currency you are selling (USD) is calculated as follows:

1.    UK     

Value of your GBP position x Interest rate ÷ 365 days = Interest received in GBP:
100,000 x 5.00% ÷ 365 = UK£13.70 (you receive on your long GBP position)

2.    US

Value of your USD position x Interest rate ÷ 365 days ÷ the GBP/USD exchange rate = Interest paid in AUD
US$195,030 x 2.00% ÷ 365 ÷ 1.9503 = UK£5.48 (you pay on your short USD position)

3.    Interest on GBP Position

Interest on GBP position - Interest on USD position = Interest rate differential
UK£13.70 – UK£5.48 = UK£8.22 (you receive on your overnight position)

The

cost/benefit (benefit in the example above) of the rollover is then

reflected as forward points as per FX market convention.

Rates based on the official overnight cash rate. This rate is subject to daily market fluctuations.

Example of a Forward Deal

A

foreign exchange swap deal is an FX deal that will have two settlement

days where currencies are simultaneously bought and sold and exchanged

on two separate days. For example, a client with an adequate margin

would like to swap a maturing contract from the current spot value day

for a month. She called XYZ corporate dealer to initiate the deal. In

this case, it will be assumed that the market is trading at about where

the deal was originally done at (i.e. 1.4350). The dialogue follows:

Client: “Hi XYZ dealer, I would like one month Sterling US in a million Sterling please, out of spot.”

YXZ dealer: “10/9.”

Client: “At 10, I sell you one million Sterling out of spot for a month. Can we make it a start rate of 1.4350, please?”

YXZ

dealer: “OK, that’s done, at 1.4350. I buy one million Sterling from

you, value 6th of June and sell it back to you 6th of July at 1.4340.

Thanks for the deal.”

Client: “Many thanks for that XYZ dealer, bye for now.”

 It

is standard practice not to have to wait more than five seconds for an

answer. The above dialogue, from the initial request for a price to its

conclusion, should not take more than half a minute.

Let’s

review some of the jargon mentioned in this short trading dialogue. The

client requests the correct FX swap, amount size and the start date of

the swap.

The client is clearly the price taker of the swap rates. The XYZ dealer responds with a two-way swap price.

The

client ‘hits’ the bid side (if it was the offer she would ‘take’ it) at

10. She then adds she would like a specific start rate – in this case

1.4350. Normal convention is to have the mid-price of the current price.

Otherwise, the actual swap points may be mid-priced.
 
The

forward dealer confirms the actual value days of the 1st and 2nd swap

settlement days. Like the spot deal in the previous section, this

concludes the agreement. Once the deal docket is passed to settlements

does the real process of confirmation, settlement and payment processing

begins.

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