Forex & CFD Basics

What is FOREX?

The international currency market FOREX (FOReign EXchange Market) is the total volume of international currency exchanges at the market exchange rate. FOREX was born in January 1976 in Kingston, Jamaica at a meeting of IMF member country ministers. This meeting introduced a new structure for the international monetary system, making free floating exchange rates the only method of currency exchange.

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  Why Forex?

  The high probability of profiting on Forex is based on the fact that every national currency is both a good (like wheat or sugar), and also a medium of exchange (like gold or silver). As the world changes, the economic conditions of every country (production, inflation, unemployment etc.) become more and more dependent on each other. As a result, the rate of a currency changes against other currencies. This is the main reason behind currency rate fluctuations.

  There are two reasons that make Forex both interesting and attractive to investors. First of all, currencies play a role as goods, necessary to everyone. For example, an American company needs JPY to pay for Japanese cars it wants to buy. At the same time, the Japanese need EUR to buy new engine parts from Germany. For various reasons, every country needs foreign currencies. The second reason Forex is popular is a result of the first. Since the supply-demand situation for every currency changes constantly, the currency rates of the buying country and selling country also change. Different factors and the economic conditions of each country also have an impact on currency rates (such as labor capacity, inflation, unemployment, etc.).

  All currencies are traded in pairs and each is assigned with an abbreviation.

  Table 1. Currency Abbreviations

  Abbreviation	Meaning
  EUR	Euro
  USD	US Dollar
  GBP	British Pound
  JPY	Japanese Yen
  CHF	Swiss Franc
  AUD	Australian Dollar
  CAD	Canadian Dollar
  NZD	New Zealand Dollar

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  Currency Exchange Rate

  A currency exchange rate is one unit of a currency expressed in terms of another. For example, when the EUR/USD exchange rate is 1.2505, it means that one Euro is exchanged for 1.2505 US Dollars.

  The exchange rate of any currency is usually shown with two figures: the Bid price (left) and the Ask price (right).

  The Bid Price represents how much of the quote currency (US Dollar in our example) will be obtained when selling one unit of the base currency (Euro in our example).

  The Ask Price represents how much of the quote currency (US Dollar in our example) has to be paid to obtain one unit of the base currency (Euro in our example).

  The Spread is the difference between the Bid and the Ask price.

  Table 2. 1.0 Lot Size for different currency pairs

  Currency pair↓	1.0 lot size	Necessary Margin for 1 lot	1 pip size
  EURUSD	EUR 100,000	1,000 EUR	0.0001
  USDCHF	USD 100,000	1,000 USD	0.0001
  EURUSD	EUR 100,000	1,000 EUR	0.0001
  GBPUSD	GBP 100,000	1,000 GBP	0.0001
  USDJPY	USD 100,000	1,000 USD	0.01

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  How to Buy/Sell a Currency Pair. Leverage.

  Let’s assume that the EUR/USD exchange rate is 1.2505/1.2509. You may have analysed the market and decided that the EUR/USD rate is moving higher (at least to 1.2600). You buy 0.1 lot (the minimum contract size) of EUR/USD at 1.2509 (the ask price). Table 2 will help you determine the contract size: for example, if 1.0 lot for EUR/USD is 100,000 EUR, then 0.1 lot (our contract size) is 10,000 EUR.

  This means that you bought 10,000 EUR and sold 10,000 × 1.2509 = 12,509 USD. That said, in order to make a deal you don’t need to have 12,509 USD available to sell but 100 times less: only $125.09. The rest of the money (in our example, $12,383.91) is leveraged to you by a broker (the company that helps you enter the market).

  Leverage is the ratio between the collateral and borrowed funds: 1:20, 1:40, 1:50, 1:100. A leverage of 1:100 means that you need to have a deposit 100 times less than the contract size to make a transaction.

  So having forecasted that EUR/USD is moving higher, you buy 10,000 EUR and sell 12,509 USD. Assume your prognosis was correct and EUR/USD reaches 1.2599/1.2603. You close the open position through the opposite transaction (in our example, you close the short position (sell position) with a long position (buy position) i.e. you sell 10,000 EUR (0.1 lot* 1.0 lot size for EUR/USD) and buy 12,599 USD):

  Transaction	EUR	USD
  Open a Position — Buy EUR and Sell USD	+ 10,000 EUR	- 12,509 USD
  Close a Position — Sell EUR and Buy USD	- 10,000 EUR	+ 12,599 USD
  Total:	0 EUR	+ 90 USD

  Your profit is 90 USD. Though you didn’t operate with 10,000 EUR (12,509 USD), but with 125 USD, the profit is 90 pips. A pip is the minimum amount a price can fluctuate. For EUR/USD, 1 pip is 0.0001 of the price (see Table 2). Our profit is 1.2599 - 1.2509 = 0.0090, i.e. 90 pips.

  Thus, you invested $125 and make a profit of $90. This can take anywhere from 10 minutes to several days. But to make a profit of $90 within several hours is definitely not a bad return. However, be aware that this can also work against you and magnify your losses. Money management will help minimize your risks, even reduce them to zero, and increase your return from 10% up to 20-30% and higher each month.

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  Rollover (Swap).

  One question is left: what does the broker charge for the leverage he provides? If you open and close a position before 23:00 GMT, a broker will provide leverage for free. If you leave your position after 23:00 GMT, the broker credits or debits from your account storage, the charge for a position held overnight. It can be either positive (credited to your account!) or negative (debited from your account), depending on the difference between the interest rates of the countries whose currencies you trade.

  For example, the European (ECB) interest rate is 4.25% and the US (FED) interest rate is 3.5%. Assume you have a short position open on EUR/USD in the size of 1.0 lot. To do this, you sell 100,000 EUR, borrowing them at 4.25% per annum. When you sell EUR, you buy USD, which you earn interest on at 3.5% per annum. As a result, your expenses are (4.25-3.5)% per annum or if the EUR/USD rate is 1.2500, 937.5 USD per year (2.57 USD per day).

  This means that $2.57 per lot will be debited from your account every day if you have a short position (sell position) on EUR/USD. If you have a long position (buy position) on EUR/USD, $2.57 will be credited to your account every day.

  In practice, the amount debited is a bit more than $2.57, and the amount credited is a bit less than $2.57. This difference goes to the broker as commission for the rollover (see Contract Specification).

  Note: Storage for the rollover of a position opened Wednesday and held overnight is three times higher than other days. This is because the value date of a trade held overnight of Wednesday would normally be Saturday, but since banks are closed, the value date is Monday and you incur or earn an extra two days of interest.

The Foreign Exchange Market (FOREX) is the most profitable sector to invest in today.

Unlike other financial markets, Forex has no physical location, in contrast with, for example, a stock exchange. It operates through an electronic network of banks, computer terminals or simply by phone. The lack of physical exchange enables the Forex market to operate on a 24-hour basis, spanning across all time zones and major financial centres (Sydney, Tokyo, Hong Kong, Frankfurt, London, New York, etc.), allowing dealers to buy and sell currencies 24 hours a day throughout the entire working week.

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  Why is Forex so popular?

  The following can be considered the main reasons why Forex is so popular among investors and financial speculators today:

  • 1. Liquidity. Forex is the largest financial market in the world, with over $3-4 trillion changing hands daily, whereas the volume traded on stock markets amounts to only $500 billion.
  • 2. Flexibility. Since Forex has a 24-hour trading schedule, you do not have to wait to react to significant events. On other markets, you simply have to wait until morning to respond and the price will already be affected by the event and greatly differ from the desired level.
  • 3. Lower transaction costs. Traditionally there are no commissions on the Forex, except for the spread (the difference between the ask and bid prices).
  • 4. Price stability. Forex's high liquidity helps ensure price stability, allowing practically unlimited contract sizes to be executed at fair prices. Instability usually happens in the stock market and other exchange-traded markets because of lower trade volumes, where only a limited number of contracts can be executed at a certain price.
  • 5. Margin. Margin size (leverage) for trading on Forex is determined through an agreement between the client and the bank or broker that gives the client access to the market, and usually is around 1:100. Thus, if a trader provides a collateral of 1,000 USD, he can make a transaction equivalent to 100,000 USD. The combination of high leverage and rapid rate fluctuation make Forex very profitable but also extremely risky.
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  Forex Market Classification.

  FOREX can be classified by the following characteristics:

  • 1. Transaction type. For example, there is an international conversion market (conversion transactions such as US Dollar / Japanese Yen or US Dollar / Canadian Dollar etc.).
  • 2. Geographic location. Unlike other financial markets the Forex market has no physical location, in contrast with, for example, a stock exchange. It operates through an electronic network of banks, computer terminals or simply by phone. The lack of physical exchange enables the Forex market to operate on a 24-hour basis, spanning across all time zones and major financial centres (Sydney, Tokyo, Hong Kong, Frankfurt, London, New York, etc.), allowing dealers to buy and sell currencies 24 hours a day throughout the entire working week. Trading begins in the Far East, in New Zealand (Wellington), then Sydney, Tokyo, Hong Kong, Singapore, Moscow, Frankfurt-on-Maine, London and finally ends in New York and Los Angeles. The approximate trading hours for regional markets are shown below:

    Japan	00:00-06:30 GMT
    Continental Europe	06:30-13:00 GMT
    Great Britain	08:30-15:30 GMT
    USA	14:30-21:30 GMT

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  Commercial Banks

  Commercial banks are responsible for the main volume of currency operations. Other market participants hold accounts in these banks and carry out necessary conversion, deposit and credit transactions through them. Banks accumulate (through client operations) market demand/market requirements in currency conversions and the attraction/investment of funds and refer with them to other banks. Aside from filling client requests, banks also trade on their own account.

  Ultimately, Forex is a market of interbank transactions, and subsequently, when discussing currency and interest rate fluctuations we need to bear in mind interbank foreign exchange market.

  Large international banks whose daily operation volumes can reach 1 billion dollars, such as Deutsche Bank, Barclays Bank, Union Bank of Switzerland, Citibank, Chase Manhattan Bank, and Standard Chartered Bank, have the largest impact on world exchange markets. These banks are distinct in that their large transaction volumes can cause significant changes in quotations or currency price. The large market players are usually divided into two groups: bulls and bears. Bulls are those market participants who want the currency price to increase; bears are those who want the price to decrease. The market is usually in balance between bulls and bears, and currency quotes usually fluctuate within a narrow range. However, when bulls or bears gain power in the market over one another, currency rates begin to fluctuate sharply and significantly.

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  Companies Carrying Out Foreign Trade Operations

  Companies that take part in international trading either have a strong demand for a foreign currency (importers) or supply a foreign currency (exporters), and also deposit and draw in currency surpluses. As a rule, these organizations do not have direct access to the Forex market and make conversion and deposit transactions through commercial banks.

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  Companies Depositing Foreign Assets (Investment Funds, Money Market Funds, International Corporations)

  These companies represent various types of international investment funds, who diversify asset portfolios by depositing funds in government bonds and securities of assorted national corporations. In dealer slang, these companies are simply called "funds". The most popular funds are George Soros's "Quantum" fund and "Dean Witter".

  This type of market participant can also refer to large international corporations making foreign industrial investments in branches, joint enterprises, etc. This describes companies such as Xerox, Nestle, General Motors, British Petroleum, and others.

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  Central Banks

  The main concern of central banks is currency regulation on the foreign market, particularly to prevent sharp bounces in national currency, thus avoiding economic crises, supporting a balance between exports and imports, etc. Central banks have a significant influence on the Forex market: both direct (currency intervention) and indirect (money supply and interest rate regulation). Central banks cannot be referred to as bulls or bears, as they may play on a rise or fall depending on their current concrete objectives. Central banks may act alone on the market to influence a national currency, or they may act in conjunction with other central banks to realise a collective currency policy on the international market or for collective interventions.

  The following banks have the largest influence on the world currency market: the US central bank — US Federal Reserve (FED), the German central bank — Deutsche Bundesbank and the British central bank — The Bank of England (Old Lady).

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  Foreign Exchanges

  Foreign exchanges operate side-by-side with emerging economies, carrying out currency exchange for legal entities and forming market exchange rates. The government usually actively regulates the exchange rate, making use of the density of currency exchange.

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  Currency Brokerage Firms

  The function of currency brokers is to bring together a buyer and a seller of a certain foreign currency and to accomplish conversion or loan-deposit operations between them. Brokers charge a brokerage commission for their mediation in a percentage of the transaction sum.

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  Individuals

  Individuals make a large amount of non-commercial transactions related to traveling abroad, salary conversions, pensions, earned income transfer, and buying or selling money on the foreign exchange market. The introduction of margin trading in 1986 gave individuals the opportunity to invest and make a profit on Forex.

  The main volume (90-95%) of transactions on Forex is completed by large global commercial banks both in their clients’ interests and on their own account. Advancement in computer technology has found more use for funds of private and retail investors by allowing more and more brokerage firms and banks to provide access to Forex through the Internet.

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There are special currency abbreviations accepted in banking practice: for example, the exchange rate for the dollar against the yen is referred to as USD/JPY, the British pound against the US Dollar is GBP/USD. The first currency is called the base currency and the second is the quote currency:

USD	/	JPY	=	120.25
Base currency		Quote currency		Rate

This abbreviation specifies how much of the quote currency you have to pay to obtain one unit of the base currency (in this example, 120.25 Japanese Yen for 1 US Dollar). The minimum rate fluctuation is called a pip.

For USD/JPY, EUR/JPY and GBP/JPY currency pairs, one pip is 0.01. For all other currency pairs (without JPY in the abbreviation), one pip is 0.0001.

Currency pairs on Forex are quoted as the bid and ask (or offer) prices:

		Bid		Ask
USD / JPY	=	120.25	/	120.30

Bid is the rate at which you can sell the base currency (in our example USD), and buy the quote currency (JPY).

Ask (or offer) is the rate at which you can buy the base currency (in our example USD), and sell the quote currency (JPY).

Spread is the difference between the bid and the ask price..

Margin trading trading on Forex using a guaranteed collateral based on the clients' funds and the leverage provided by the dealer.

This means that a client makes a minimum deposit as collateral, which is much smaller than the minimum contract, but can operate with the larger amounts necessary to enter the real market. These extra funds are provided to the client by brokers along with their informational services and make it possible for a trader to work with positions larger than their account balance. This collateral is typically referred to as margin.

Leverage is the ratio between the collateral and borrowed funds: 1:20, 1:40, 1:50, 1:100. A leverage of 1:100 means that you need to have a deposit 100 times less than the contract size to make a transaction.

Currency Rate is the value of one currency expressed in terms of another. The fluctuation depends on the supply and demand on the market and/or open market operations by a government or central bank.

Lot is a fixed standard amount of a currency for trading provided on the collateral — margin. It is sometimes called the contract size. The 1.0 lot contract size for each currency pair is listed in the Contract Specification.

Storage is the charge to rollover a position overnight. It can be either positive (credited to your account balance!) or negative (debited from you account balance) depending on the difference between the interest rates of the countries whose currencies you trade.

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In the past few years, CFDs (Contracts for Difference) have become increasingly popular as financial trading instruments. What exactly has contributed to their popularity?
A contract for difference (CFD) is an agreement between two parties to exchange the difference in value between the opening price and closing price of a contract when it is brought to a close.

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  Why are CFDs popular?

  • 1. Short selling. CFDs allow you to profit in both rising and falling markets by providing the opportunity to go short, selling assests borrowed from a third party with the intention of buying them back at a later date to return to the lender. This earlier was only available for professional investors. Selling short is more cost-effective and easier than buying shares.
  • 2. Low margin requirements. You can make transactions without having the full contract and provide the margin, which is 5 to 10 percent of the transaction size. This allows you to trade full portfolio investments without tying up all of your funds.
  • 3. Market prices. You are provided market spreads with no widening, which allow you to trade at the same price as stock market professionals.
  • 4. High-speed execution. Deals are executed immediately with no waiting period.
  • 5. Markets. At the present time, you have the opportunity to trade shares in the Dow Jones industrial index and stock indexes. In the future, the range of markets offered will expand.
  • 6. Transaction size. The minimum transaction size for CFDs is 0.1 lot (10 shares). That said, the necessary margin will be approximately 10 to 150 USD (depending on the price of a specific share). The necessary margin for the minimum contract will be approximately 35 to 70 USD when trading on major US stock indexes (prices at the end of February 2003).
  • 7. Hedging strategies. If you are a shareholder and do not intend to sell your shares even if prices fall, you can open a short position on the CFD for that share (or the whole portfolio). Your losses on the underlying asset will then be compensated by the profit on the corresponding CFD.

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Imagine a contract requiring a seller to supply a buyer certain assets at an agreed date in the future. Though this contract is determined by the purchase price, the asset is not paid until the delivery date (final settlement). Nevertheless, the seller and buyer are required to make post performance bonds upon signing the contract. These bonds protect either party from losses if the other party should abandon the contract. Thus, the performance bond size is reviewed daily to ensure adequate protection. In the case it is too large, the excess can be reclaimed.

 

These contracts are called futures contracts, or futures for short.

In the US, there are futures for the following types of assets:

• agricultural products (wheat, corn, soybeans, etc.);
• natural resources (gold, copper, crude oil, natural gas, etc.);
• foreign currency
• fixed-income securities (treasury bonds, etc.);
• stock indexes (S&P 500, NASDAQ and others).

Futures contracts are quite easy to establish due to their standard terms and in the near future, any person will be able to trade them.

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  Hedgers and Speculators.

  Futures include two types of participants - speculators and hedgers. Speculators buy and sell futures with the sole purpose of obtaining capital gain, closing their positions at a better price than the original. These individuals have no practical use for underlying assets within the constraints of their normal business. Hedgers, on the other hand, buy and sell futures to avoid risky positions on the spot market. They have an actual interest in the underlying asset and typically either produce or consume it in their regular course of business.

  Example of hedging. Let's consider wheat futures. A farmer notes that the market price for wheat futures with delivery around harvest is now $4 per bushel, enough to make a profit for the year. The farmer could sell wheat futures today, but could also wait until harvest and sell the grain at that time on the spot market. Delaying until harvest poses a risk, since by that time the price of wheat could fall to $3 per bushel, leading to the farmer's financial demise. In contrast, selling the wheat futures today allows the farmer to lock the price at $4 per bushel, thus protecting their business from risk. This farmer selling futures is called a hedger or, more precisely, a short hedger.

  The buyer of the farmer's futures contract could be a baker who uses the wheat to bake bread. The baker has some stores of wheat that will last until harvest. In order to replenish his stock, the baker can buy a futures contract now at $4 per bushel. The baker could also simply wait until the moment when his stock is depleted and buy wheat on the spot market. However, it is possible that by that time the spot price will be $5 per bushel. If this happens, the baker will need raise the price of bread, and possibly incur losses from a decline in sales. However, the wheat futures buyer (the baker) can guarantee a purchase price of $4 per bushel through a futures contract, thus eliminating the risk in the process of making bread. The baker buying futures is known as a hedger or, more precisely, a long hedger.

  Example of speculation. In contrast with our farmer and baker, a speculator buys and sells wheat futures based on price forecasts in order to profit in a relatively short time period. As stated above, a speculator does not produce or consume the underlying asset within their normal business.

  A speculator who is of the opinion that the price of wheat will grow substantially will buy wheat futures. He will later make a reversing trade selling back the wheat futures. If the forecast was accurate, he will profit on the higher price for wheat futures. For example, consider a speculator anticipating an increase in spot prices for wheat, at least by $1 per bushel. Despite the fact that a person could buy wheat and store it, hoping to sell later at a higher price, it is much easier and more profitable to buy wheat futures today at $4 per bushel. Afterwards, assuming that the price of wheat rises by $1, a speculator will reverse the transaction by selling the wheat futures at $5 per bushel (rising spot prices for wheat by $1 also increase futures prices by about $1). Thus, the speculator will gain $1 per bushel, or a total profit of $5,000, since the size of a wheat contract is 5,000 bushels. The speculator must post a $675 performance bond when purchasing the futures contract, which will be returned when he makes the reversing trade. In such a manner, the speculator receives a relatively high rate of return (740%) in relation to the increase in the price of wheat (25%). On the other hand, if the speculator expects a significant price fall, he first sells wheat futures, later reversing the transaction by buying them back. If his prediction is accurate, he will benefit from the lower prices on wheat futures.

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  Futures Contract.

  Futures are standardized in their terms of delivery as well as in the specification of the underlying asset authorised for delivery.

  For example, the Chicago Board of Trade (CBOT) determines the following requirements for July wheat futures:

  • The seller is ready to deliver 5,000 bushels of a certain variety of wheat (No. 2 Soft Red, No. 2 Hard Red Winter, No.2 Dark Northern Spring, No. 1 Northern Spring) at the agreed price. Other wheat varieties may be delivered on the terms of a specified bonus or discount regarding the agreed price. In any case, the seller holds the right to decide which wheat variety will be delivered.
  • Wheat is delivered by way of warrant issued by either the Chicago or Toledo (Ohio) grainery.
  • Delivery will take place in July and the seller chooses the date of delivery.
  • When the warrant is passed on to the buyer, he pays the seller the agreed price in monetary form.

  Once the exchange has set all the terms of the futures contract, except the price, it consents to contracts being sold. Buyers and sellers (or their representatives) meet at a predetermined place in the exchange's trading hall and try to agree on the transaction price. If they manage to come to an agreement, one or more contracts are drawn up. All contract terms are standardized and price is added as a new term. Prices are usually set based on one unit of the asset. Thus, if the buyer and seller agree to $4 a bushel for a contract of 5,000 bushels, the total contract price will be $20,000.

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CFD is an example of margin trading, which allows an investor to take more profit using leverage. This means that an investor can buy CFDs without having adequate funds to purchase shares. For example, to buy Microsoft shares at $10,000, you only need a deposit of $1,000. If you make a profit of $1,000, your return is 10% trading the underlying assets, but trading CFDs, your return is 100%. However, it is important to keep in mind that losses are calculated in the same way.

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  Advantages of CFDs.

  A contract for difference can be described as purchasing shares on credit. If you buy a CFD, you get all the benefits of owning that share, including rise in value and dividends, but you need to pay the lending expenditures to the seller. It’s in a way like a loan from a bank to buy shares: you get the benefits of a shareholder and the bank makes interest on your loan. CFDs combine this process into one transaction.

  If you trade CFDs, you will not receive the same dividends as real shareholders as you must undergo the "Dividend Adjustment". This means that if you have open positions on a day called the ex-dividend date when the records are fixed, your account will be credited or debited to reflect those adjustments. If you have a long position, the adjusted amount is credited and if you have a short position, it is debited. Dividend adjustments are calculated on the basis of dividends per share. You can find more information on the crediting/debiting of share CFD dividends on the page Dividends for Share CFDs.

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  Long position.

  You've decided to purchase Microsoft shares, and having received the quote 23.97/24.00, you buy 100 shares at $24.00. Thus:

  Microsoft share value	$24.00
  Number of shares	100
  Transaction size	$2,400.00
  Margin (10%)	$240.00

  To make this deal you need to have at least $240.

  Credit Settlements

  Credit settlements are required when you leave a position open until the end of a trading session. Credit settlements are calculated based on the FED Funds Rate (for US Stocks) and the closing price of the share.

  For example: the FED Funds rate is 1.75%, and the closing price of Microsoft shares is $25.00. So, your credit settlement is calculated using the following method:

  N_Stocks x P_Close x Interest / N_Days =
  = 100 x $25.00 x (1.75% + 1.25%) / 360 =
  = $0.208

  Closing a Position

  Three days later, Microsoft shares are quoted at 25.50/25.53, and you choose to close your position by selling at $25.50:

  Microsoft share value	$25.50
  Number of shares	100
  Transaction size	$2,550.00
  Profit	+ $150.00
  Credit settlements (3 days)	- $0.63
  Profit less credit expenditures	+$149.37 (+ 150.00 - 0.63)

  The transaction profit is 61% of the original investment.

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  Short position.

  Let’s assume that American Express shares are overpriced and you decide to sell 200 American Express CFDs. They are quoted at 33.90/33.94, thus you sell the 200 AXP CFDs at $33.90.

  American Express share value	$33.90
  Number of shares	200
  Transaction size	$6,780.00
  Margin (10%))	$678.00

  To make this deal, you need to have at least $678.00.

  Credit Settlements

  Credit settlements are required when you leave your position open until the end of a trading session. Credit settlements are calculated based on the FED Funds Rate (for US Stocks) and the closing price of the share. Let's say that the FED Funds Rate is 1.75%, and the closing price for AXP shares is 33.10. Your account will be credited as follows:

  N_Stocks x P_Close x Interest / N_Days =
  = 200 x $33.10 x (1.75% - 1.25%) / 360 =
  = $0.09

  Closing a Position

  Seven days later, AXP shares are quoted at 33.36/33.40 and anticipating further growth, you decide to close the position by buying 200 AXP CFDs at $33.40.

  American Express share value	$33.40
  Number of shares	200
  Transaction Size	$6,680.00
  Profit	+ $100.00
  Credit settlements (7 days)	+ $0.63
  Profit less credit expenditures	+ $100.63

  Your return on your initial investment is 14%.

  Contract Specification

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Trading financial instruments linked to Stock Indexes is becoming more and more popular every day.

Index investment means that you closely track the price and yield performance of any index. In order to do this, you build your investment portfolio with instruments that track the index. The large quantity of shares tools can help investor to build a diversified portfolio.

It's difficult for small investors and traders to invest in NASDAQ 100 or S&P 500, because you need to have more than one share of any company listed in these indexes. Thus, until just recently, only professional investors with million-dollar portfolios could invest in indexes.

The first step in opening up this type of investment to small traders was in 1993 when the S&P unit investment trust was introduced. Known as "Spiders," a SPDR (Standard & Poor's Depositary Receipt) share represents 500 stocks of the Standard & Poor's 500 Composite Stock Price Index (S&P 500). The shares are traded under the ticker SPY and the price is equal to 1/10th of the current value of the S&P 500 Index.

Further steps were taken in 1997 when DIAMONDS, an index product based on the Dow Jones Industrial Average, appeared on the market (DIA, trade around 1/100th of the value of the Dow). Then, in 1999 the NASDAQ 100 Trust was introduced (QQQ (Cubes), trade around 1/40th of the value of the NASDAQ 100).

With these developments, millions of investors were given the opportunity to invest in indexes. On May 14, 2003, the prices were:

• SPY - $94.71
• DIA - $87.04
• QQQ - $28.66

Generally, investors like trading Cubes, Diamonds and Spiders since you don't need to be a market pro to understand and trade them. Their volumes are much higher than trading other shares and there is no need to make an in-depth analysis of each corporation as ETFs reflect the large-scale macroeconomic factors.

The main points you need to pay attention to are noted below:

• 1. The value of index share is not fixed and depends on supply and demand. However, the approximate ratio to their corresponding stock index is as follows:
  • SPY - 1/10 of the value of the S&P 500
  • DIA - 1/100 of the value of the DJIA 30
  • QQQ - 1/40 of the value of the NASDAQ 100
• 2. The price differentials between the shares and underlying indexes present a great opportunity for arbitrage. This arbitrage is called "Program Trading" because it's so widespread and computerized. The US Government Security and Exchange Commission (SEC) controls the American Stock Exchange and releases information on the Program Trading volume daily, which is usually no less than 30% of the exchange's total volume.
• 3. Index trust shares are highly liquid. Day volume can exceed 100 million shares.
• 4. At the beginning of 2002, the stock exchange assets were more than $82 billion.
• 5. Dividends on SPY and QQQ shares are paid quarterly and because of the nature of the listed companies, the dividends are rather small. Dividends on DIA shares are paid monthly.

All this combined makes a great trading instrument for small investors who might not have sophisticated knowledge of the fundamental indicators of each separate company.

Contract Specification

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