The History of the Forex Market

The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of well over US$1 trillion -- 30 times larger than the combined volume of all U.S. equity markets.

"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).

There are two reasons to buy and sell currencies. About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency. The other 95% is trading for profit, or speculation.

For speculators, the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.

A true 24-hour market, Forex trading begins each day in Sydney, and moves around the globe as the business day begins in each financial center, first to Tokyo, London, and New York. Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur - day or night.

The FX market is considered an Over The Counter (OTC) or 'interbank' market, due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. Trading is not centralized on an exchange, as with the stock and futures markets.

Understanding Forex Quotes

Reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1.

The US dollar is the centerpiece of the Forex market and is normally considered the 'base' currency for quotes. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 120.01 means that one U.S. dollar is equal to 120.01 Japanese yen.

When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before.

The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.

In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.

In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.

Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.

When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'offer'. The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency). The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency).

Basic Facts About Options

From Ken Little, About.com

An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date.

Investors buy and sell options just like stocks. There are two basic types of options:

-The call option
-The put option
-The Call Option

The call option is the right to buy the underlying security at a certain price on or before a certain date.

You would buy a call option if you anticipated the price of the underlying security was going to rise before the option reached expiration. For example:

Company XYZ in trading at $25 per share and you believe the stock is headed up. You could buy shares of the stock or you could buy a call option. Say a call option giving you the right, but not the obligation, to buy 100 shares of XYZ anytime in the next 90 days for $26 per share could be purchased for $100.

If you are right and the stock rises to $30 per share before option expires, you could exercise your option and buy 100 shares at $26 per share and sell them for an immediate profit of $3 per share ($30 - $26 = $4 - $1 for the option = $3 per share profit).

You could also simply trade the option for a profit without actually buying the shares of stock.

If you had figured wrong and the stock went nowhere or fell from the original $26 per share to $24 per share, you would simply let the option expire and suffer only a $100 loss (the cost of the option).

The Put Option
The put option is the right to sell the underlying security at a certain price on or before a certain date.

You would buy a put option if you felt the price of a stock was going down before the option reached expiration.

Continuing with out XYZ example, if you felt the stock was about to tank from $25 per share, the only way to profit would be to short the stock, which can be a risky move if you’re wrong.

You could purchase a put option at $24 per share for $100 (or $1 per share), which would give you the right to sell 100 shares of XYZ at $24 per share.

If the stock drops to $19 per share, you could, in theory buy 100 shares on the open market for $19 per share, then exercise you put option giving you the right to sell the stock at $24 per share – making a $5 per share profit, minus the option cost.

As a practical matter, you would trade your put option, which would now be worth something close to $5 per share or $500.

Basic Option Facts
Here are some quick facts about options:

Options are quoted in per share prices, but only sold in 100 share lots. For example, a call option might be quoted at $2, but you would pay $200 because options are always sold in 100-share lots.

The Strike Price (or Exercise Price) is price the underlying security can be bought or sold for as detailed in the option contract. You identify options by the month they expire, whether they are a put or call option, and the strike price. For example, an “XYZ April25 Call” would be a call option on XYZ stock with a strike price of 25 that expires in April.

The Expiration Date is the month in which the option expires. All options expire on the third Friday of the month unless that Friday is a holiday, then the options expire on Thursday.

Conclusion
This quick overview of options gives you an idea of what they are all about, but it is the very tip of the proverbial iceberg. Options are not for the beginning investor, but do offer advanced traders another tool for their investment arsenal.

Note: All option quotes in this article are for illustration only. Pricing of options is a complicated process involving many factors.

What is the Stock Price

From F. John Reh, About.com

Definition: The Strike Price is the price at which the holder of a stock option may purchase the stock.

If the strike price is below the price at which the stock is trading on the open market, the option holder may be able to make a profit. If the stock price on the open market is below the strike price, the options are said to be "underwater". It would make no sense to exercise an "underwater" option because that would mean buying the stock through the stock option at a higher price than you would pay on the open market.

Examples: An employee is issued a stock option grant of 100 shares of company XYZ at a strike price of $6, but must hold the options for one year until they vest. After one year, the employee may exercise the option and purchase 100 shares of XYZ for $600. If XYZ is trading for $12 on the stock market, the employee may sell those 100 shares for $1200, less commissions and other brokerage fees.

Online Trading vs. Direct Access Trading

From Alvaro Oliveira, About.com

The key features and differences of interest to beginning day traders

There are two ways to day trade electronically, namely:

1. Conventional online trading using your Internet browser and a Web based broker

2. Direct Access Trading systems using specialized software and a private network

It is important for day traders to understand the key features of, and the differences between, these two forms of electronic trading.

Conventional online brokers provide Web based trading whereby the client logs in through the broker's Web site and places orders through his Internet browser. By the time client loads his browser, waits for the broker's Web page to load, logs in, enters his order, and the broker reviews the order, several minutes may have elapsed. Further time may elapse before the order is actually executed after being received and reviewed by the online broker because several intermediaries may be involved in handling the order.

In this regard, many online brokerage firms do not always themselves execute client orders directly, but rather may send the orders to other market makers for execution. This can result in slow execution of orders at a higher price than the client may have expected. This is bad news for day traders, as execution speed is critical for successful day trading.

By way of contrast, Direct Access Trading (DAT) systems allow one to trade stock directly with a market maker or a specialist on the floor of the exchange, using special trading software and high-speed computer linkages to the Nasdaq, NYSE and the various Electronic Communications Networks (ECNs). With a DAT trading platform, a trader may place orders directly into the market in real-time and trade directly with a market maker on Nasdaq, a specialist on the floor of the NYSE, or with an ECN, without any broker participation at all. There are no middle-men involved between the relevant stock exchanges, ECNs and the individual trader. If there is a sufficient number of shares available at the price specified by the trader, the order is executed in a fraction of a second and a confirmation is instantly displayed on the trader's computer screen. Because no middle-man is involved, the trader will save anywhere from a few seconds to several minutes of time to complete a typical trade. Accordingly, the major advantage of a DAT system is that it results in much faster executions than one can normally achieve using a conventional online broker.

Another major advantage of using a DAT over a conventional online broker is that, by using a DAT platform, a trader may choose a specific market maker or ECN that he wants the order sent to. A DAT system will provide the trader with access to Nasdaq Level II quotes, thereby allowing him to see, in real-time, all of the available prices for each ECN and market maker. The trader can then route his order to that particular ECN or market maker where he thinks he is most likely to get the best price. With a conventional online broker, the trader has no control over where the order is sent and, in any event, relatively few online brokers provide their clients with Nasdaq Level 11 quote information.

Most firms who supply DATs charge commissions based on a scale which depends on the number of trades that a trader makes over a given time period, plus a small additional fee for trades placed with an ECN. The greater the number of trades, the lower the commission per transaction. Commissions typically range from $10 to $15 for a 1000 share transaction. In addition, most DAT suppliers charge a fee for the use of their proprietary trading software, usually in the range of $100 to $300 per month. However, this charge is sometimes waived if a trader makes a minimum number of trades per month.

In summary, as compared with conventional online brokers, day trading firms offer better access to the markets, much faster executions, and greater control in order routing.

Options Pricing Model

From Alvaro Oliveira, About.com

The Black-Scholes option valuation model consists of a rather complex mathematical formula developed by two famous economists in the early 1970's, which permits one to calculate what the "theoretical" price of an equity option should be. The following describes the major determinants of the value of a stock option which the Black-Scholes model takes into account.

Strike Price

At any point in time, an option's intrinsic value, if any, is computed by reference to the difference between the strike (exercise) price of the option and the current underlying share price. In the case of a call option, if the current share price is below the strike price, then the option is said to be "out of the money" and has no intrinsic value.

Conversely, if the current share price is higher than the strike price of a call option, then the option is "in-the-money" and has intrinsic value. In the case of put options, the same applies in reverse.

Time Until Expiry

All other things equal, the price of stock options decreases at an accelerating rate as the expiration date approaches. This is referred to as "time decay" and is the primary reason that long-term options are more expensive than short-term options in the same underlying stock.

Volatility

In simple terms, volatility is a measure of "how much the stock moves around" - whether up or down. There are two types of volatility. Historical (actual) volatility can be determined mathematically based on the size of price moves that a particular stock has actually made in the past. Implied (future) volatility refers to the degree of price volatility that a particular stock is anticipated to make in the future. Different investors may have significantly different expectations about the future volatility of a stock. Hence, there will often be different perceptions of what the "fair" price of a particular stock option should be. Historical volatility is, however, often used as an estimate of the future volatility of a stock to value a stock option.

Prevailing Risk-Free Interest Rate

The prevailing risk-free interest rate also affects option prices. When an investor buys an option, he has to pay an amount (premium) for the option contract. If he did not buy that option, the investor could have placed the amount of the option premium on time deposit and earned risk-free interest on it. The option price or premium will therefore reflect this lost interest. In particular, the higher the prevailing interest rate, the more lost interest and hence the lower the option premiums have to be to compensate for that foregone interest. In practice, when interest rates are very low, this effect is negligible and is often ignored when valuing an option - particularly a short-term option.

Dividends to be Paid

Dividends that are due to be paid out on the underlying shares during the period of the option will reduce the price of the stock by that amount when actually paid out. This will have the effect of reducing the price of call option premiums and increasing put premiums. Accordingly, the anticipated payment of dividends must be taken into account when valuing options.

Online Black-Scholes Calculator

If you wish to calculate the theoretical value of a specific stock option using the Black-Scholes model you may do so by using the free and easy-to-use online calculator found at Schaeffer's Investment Research.

Understanding Earnings Per Share

From Ken Little, About.com

One of the challenges of evaluating stocks is establishing an “apples to apples” comparison. What I mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision.

Comparing the price of two stocks is meaningless as I point out in my article “Why Per-Share Price is Not Important.”

Similarly, comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares.

For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own?

It makes more sense to look at earnings per share (EPS) for use as a comparison tool.

You calculate earnings per share by taking the net earnings and divide by the outstanding shares.

EPS = Net Earnings / Outstanding Shares
Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).

So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.

You should note that there are three types of EPS numbers:

  • Trailing EPS – last year’s numbers and the only actual EPS
  • Current EPS – this year’s numbers, which are still projections
  • Forward EPS – future numbers, which are obviously projections

How Much Does a Stock Cost?

From Ken Little, About.com

That’s like asking how long is a piece of string. The answer is ‘it depends.’

Once a stock moves out of the IPO stage and into the open market, there are a number of factors that go into setting the price.

Opening Price
For example, Amalgamated Kumquats closes on Tuesday at 25½; what will it open at on Wednesday morning? The answer is: who knows. Most likely, it will open somewhere around 25½, but any number of things might cause it to open higher or lower. Before the market opens on Wednesday:

  • Civil war in Elbonia, the prime producer of Kumquats
  • President of Amalgamated Kumquats arrested for looting the company
  • FDA says Kumquats cure baldness
  • Huge oil reserves discovered on Amalgamated property

All of these circumstances and many others could influence the price up or down.

In the end, it remains a question of what a buyer is willing to pay and a seller is willing to take.

The swirl of market, political, and industry news influences whether there are more buyers or sellers for a particular stock in the market at any one time.

Clean Slate
Every day the market opens, it’s a clean slate. Investors must meet no set prices. Stocks that the day before were flying high may not get off the ground today. The ugly duckling turns into a cash cow (how’s that for mixing metaphors).

The point is a share of stock is worth what someone else is willing to pay for it. That is the heart of investing. A stock may be a good buy at $35 per share and a terrible buy at $50 per share to one investor, however another investor may not think twice about paying $50 per share. Which is the right price? Often only time will tell. Many years ago, some investors thought $10 per share was too much for Microsoft and refused to buy it. Too bad for them.

Fair Price
Successful investors decide what a fair price for a particular stock is and that’s where they buy. They don’t let market hysteria goad them into overpaying. Likewise, if nothing has fundamentally changed with the company, but the stock is dropping along with the market, successful investors will sit tight and not be frightened off a good price.

As you develop you investing skills, you will learn strategies and techniques to help you establish a fair price for stocks and either get that price or find another stock to buy that meets you investing criteria.