A Primer On The Forex Market
With the widespread availability of electronic trading networks, trading currencies is now more accessible than ever. The foreign exchange market, or forex, is notoriously the domain of commercial and investment banks, not to mention hedge funds and massive international corporations. At first glance, the presence of such heavyweight entities may appear daunting to the individual investor. But the presence of such powerful groups and such a massive international market can also work to the benefit of the individual trader. The forex market offers trading 24 hours a day, five days a week. It is the largest and most liquid market in the world. According to Bank For International Settlement, trading in foreign exchange markets averaged 5.3 trillion per day in 2013.
The sheer number of currencies traded serves to ensure an extreme level of day-to-day volatility. There will always be currencies that are moving rapidly up or down, offering opportunities for profit (and commensurate risk) to astute traders. Yet, like the equity markets, forex offers plenty of instruments to mitigate risk and allows the individual to profit in both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements relative to its equity counterparts.
Many instruments utilized in forex – such as forwards and futures, options, spread betting, contracts for difference (CFD) and the spot market – will appear similar to those used in the equity markets. Since the instruments on the forex market often maintain minimum trade sizes in terms of the base currencies (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is absolutely essential for the person trading these instruments.
Buying and Selling Currencies
Regarding the specifics of buying and selling on forex, it is important to note that currencies are always priced in pairs. All trades result in the simultaneous purchase of one currency and the sale of another. This necessitates a slightly different mode of thinking than the way required by equity markets. While trading on the forex market, you would execute a trade only at a time when you expect the currency you are buying to increase in value relative to the one you are selling.
Base and Counter Currencies and Quotes
Currency traders must become familiar also with the way currencies are quoted. The first currency in the pair is considered the base currency; and the second is the counter or quote currency. Most of the time, the U.S. dollar is considered the base currency, and quotes are expressed in units of US$1 per counter currency (for example, USD/JPY or USD/CAD).
Forex quotes always include a bid and an ask price. The bid is the price at which the market maker is willing to buy the base currency in exchange for the counter currency. The ask price is the price at which the market maker is willing to sell the base currency in exchange for the counter currency. The difference between the bid and the ask prices is referred to as the spread.
The cost of establishing a position is determined by the spread. Most major currency pairs are priced to four decimal places, the final digit of which is referred to as a point or a pip. For example, if USD/JPY was quoted with a bid of 134.3919 and an ask of 134.3923, the four-pip spread is the cost of trading this position. From the very start, therefore, the trader must recover the four-pip cost from his or her profits, necessitating a favorable move in the position simply to break even.
More About Margin
Trading in the currency markets also requires a trader to think in a slightly different way about margin. Margin on the forex market is not a down payment on a future purchase of equity but a deposit to the trader’s account that will cover against any future currency-trading losses. A typical currency trading system will allow for a very high degree of leverage in its margin requirements, up to 100:1. The system will automatically calculate the funds necessary for current positions and will check for margin availability before executing any trade.
In the spot forex market, trades must be settled within two business days. For example, if a trader sells a certain number of currency units on Wednesday, he or she must deliver an equivalent number of units on Friday. But currency trading systems may allow for a “rollover” with which open positions can be swapped forward to the next settlement date (giving an extension of two additional business days). The interest rate for such a swap is predetermined, and, in fact, these swaps are actually financial instruments that can also be traded on the currency market.
In any spot rollover transaction, the difference between the interest rates of the base and counter currencies is reflected as an overnight loan. If the trader holds a long position in the currency with the higher interest rate, he or she would gain on the spot rollover. The amount of such a gain would fluctuate day-to-day according to the precise interest-rate differential between the base and the counter currency. Such rollover rates are quoted in dollars and are shown in the interest column of the forex trading system. Rollovers, however, will not affect traders who never hold a position overnight since the rollover is exclusively a day-to-day phenomenon.
As one can immediately see, trading in forex requires a slightly different way of thinking than the way required by equity markets. Yet, for its extreme liquidity, multitude of opportunities for large profits due to strong trends and high levels of available leverage, the currency market is hard to resist for the advanced trader. With such potential, however, comes significant risk, and traders should quickly establish an intimate familiarity with methods of risk management.