While Forex (FX) is the largest financial market in the world, it is largely unknown to retail traders. Before the popularization of internet currency trading, FX was mainly the realm of major financial companies, multinational corporations, and hedge funds. However, times have changed, and individual retailers are now hungry for details on forex.
If you are an FX beginner or just need a refresh course on the fundamentals of currency trading, here are the answers to some of the most frequently asked questions on the FX market.
1. How does Forex compare with other markets?
Unlike stocks, futures or options, currency trading does not take place on a regulated market and is not governed by any central governing body. There are no trading houses to guarantee trade, and there is no arbitration court to settle disputes. All members transact with each other on the basis of credit agreements. Essentially, business in the world’s biggest, most liquid economy relies on nothing more than a metaphorical handshake.
At first glance, this ad hoc system is confusing for investors who use standardized markets such as the New York Stock Exchange ( NYSE) or the Chicago Mercantile Exchange (CME). However, this method is operating in practice. Self-regulation provides efficient market leverage, as FX participants must collaborate and cooperate. In addition, respectable FX dealers in the United States become members of the National Futures Association (NFA), and, by doing so, FX dealers commit to joining arbitration in the case of any conflict. It is therefore important that any retail customer considering currency trading do so only through an NFA member company.
In other special respects, the FX market is distinct from other markets. Traders who assume that EUR / USD will spiral downwards may shorten the pair at will. There is no uptick rule in FX as there is in stock. There are also no limitations on the size of your place (as in the future). Thus, technically, a trader would be able to sell $100 billion worth of money if they had adequate resources.
In another sense, the trader is free to act on information in a manner that would be deemed to be insider trading in conventional markets. For example, a trader learns from a client who happens to know the governor of the Bank of Japan (BOJ) that the BOJ expects to increase rates at its next meeting; the trader is free to purchase as much yen as possible. There is no such thing as insider trading in FX — European economic statistics, such as German job data, are often leaked days before they are officially released.
Before we leave you with the idea that FX is the Wild West of Finance, please remember that this is the most liquid and flexible market in the world. It runs 24 hours a day, from 5 p.m. EST Sunday at 4 p.m. EST Friday, and there are few price differences. Its sheer scale and complexity (from Asia to Europe to North America) make the currency market the most available in the world.
2. What’s up with the Forex Commission?
Investors who exchange stocks, futures, or options usually use a broker who serves as an intermediary for the deal. The broker shall take an order for an exchange and shall attempt to conduct it in compliance with the orders of the client. The broker shall be paying a fee on the purchase and sale by the customer of the tradable instrument for the provision of this service.
There are no commissions on the FX market. In comparison to exchange-based markets, FX is a principal market. FX companies are retailers, not brokers. Unlike traders, dealers bear market risk by acting as an investor’s counterparty. They don’t charge a commission; instead, they distribute their money into a bid-ask.
In FX, the investor can not, as is the case in exchange-based markets, attempt to buy on the bid or sell on the offer. On the other side, if the price has exceeded the cost of the spread, there are no extra fees or commissions. Every single penny you raise is a pure profit to the investor. However, the fact that traders must always resolve the spread of bids / asks makes scalping a lot more difficult in FX.
- Currency trading is based on credit arrangements that are nothing more than a metaphorical handshake.
- FX trading is self-regulated so participants must collaborate and cooperate.
- There is no uptick rule in FX as there is in stock. Unlike futures, there are no restrictions on the scale of the position of the seller.
- FX traders usually use brokers who charge commission fees.
- The pip is a percentage point which is the smallest rise in FX trading.
3. What’s the Pip?
Pip stands for percentage in point and is the smallest rise in FX exchange. In the FX segment, rates are quoted at the fourth decimal point. For eg, if the soap bar in the drug store was priced at $1.20, the same soap bar would be quoted on the FX market at 1.2000. The difference in the fourth decimal point is called 1 pip and is normally equal to 1/100th of 1%. Among the major currencies, the only exception to this law is the Japanese yen. One dollar is worth about 100 Japanese yen; thus, in the USD / JPY pair, the quotation is limited to only two decimal points ( i.e. 1/100th of yen, as opposed to 1/1000th of other major currencies).
4. What are you thinking doing trading?
The short response is none at all. The FX retail market is a strictly speculative market. No actual currency exchange has ever taken place. All trades exist simply as machine entries and are based on market prices. In the case of dollar-denominated accounts, all gains or losses are measured in dollars and reported as such on the account of the dealer.
The primary reason for the existence of the FX market is to promote the conversion of one currency into another for multinational companies that need to constantly trade currencies (i.e. salaries, payment of products and services from international suppliers, mergers, and acquisitions). However, these day-to-day business needs reflect just about 20% of the market value. Eighty percent of transactions in the currency market are speculative in nature by major financial firms, multi-billion dollar hedge funds, and individuals who wish to share their views on the economic and geopolitical events of the day.
Since currencies often trade in pairs, when a trader trades, the trader is always long in one currency and short in the other. For example, if a trader sells a regular lot (equivalent to 100,000 units) of EUR / USD, they would have exchanged euros for dollars and would now have been short euros and long dollars. To better understand this equation, a person who purchases a device from an electronics store for $1,000 will trade dollars for a device. That guy’s a short $1,000 and a long machine. The store might have been a long $1,000, but now it’s short of a machine in its inventory. The same idea applies to the FX market, except that there is no actual trade. While all transactions are simple database entries, the effects are no less true.
5. What is Forex Exchange Currency?
While some traders trade exotic currencies such as the Thai Baht or the Czech Koruna, the majority of dealers trade the world’s seven most liquid currency pairs, the four majors:
- EUR / USD (EUR / dollar)
- USD / JPY (dollar / yen Japanese)
- GBP / USD (Britain pound / dollar)
- USD / CHF (USD / Swiss franc)
And the three pairs of commodities:
- AUD / USD (USD / USD dollar)
- USD / CAD ($/Canadian dollar)
- NZD / USD ($/dollar in New Zealand)
These currency pairs along with their different combinations (such as EUR / JPY, GBP / JPY, and EUR / GBP) account for more than 95 percent of all speculative trading in FX. Given the small number of trading instruments, only 18 pairs and crosses are actively traded, the FX market is much more concentrated than the stock market.
6. What is the currency exchange trade?
Carry is the most common currency trading market practiced by both the largest hedge funds and the smallest retail speculators. Carrying trade is focused on the fact that every currency in the world has an associated interest. These short-term interest rates are determined by the central banks of these countries: the Federal Reserve in the United States, the Bank of Japan in Japan, and the Bank of England in the United Kingdom.
The concept of carrying is simple. The investor spends a long time in a currency with a high-interest rate and funds that he purchases with a currency with a low-interest rate. For example, the NZD / JPY cross was one of the best pairings in 2005. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, saw its rates rise to 7.25 percent and stay there while Japan remained at 0 percent. A long-term trader on the NZD / JPY could have produced 725 basis points in yield alone. On a 10:1 leverage basis, NZD / JPY carry trade could have provided a 72.5 percent annual interest rate difference without any capital appreciation contribution. This example shows why carrying trade is so common.
Before rushing out in search of the next high-yield pair, it should be advised that when the carrying trade is unwound, the decline can be rapid and serious. This process is known as currency carrying trade liquidation and happens when the majority of speculators conclude that carry trade does not have future value. For any trader trying to exit their position at once, bids vanish, and interest rate differential gains are not nearly enough to cover capital losses. Anticipation is the key to success: at the beginning of the rate-tightening period, the best time to position the carry is to allow the trader to switch as interest rate differentials increase.
Forex Jargon Other
Every discipline has its own jargon, and the currency market is no different. Here are some of the words that the experienced currency trader should know:
- Cable, sterling, pound: slang for GBP.
- Greenback, buck: nickname for the U.S. dollar
- Swissie: the Swiss franc’s nickname
- Aussie: nickname of the Australian dollar
- Kiwi: nickname of the New Zealand dollar
- Loonie, the little guy: the nickname for the Canadian dollar
- Figure: FX word connoting a round number as 1.2000
- Yard: a billion units, like “I sold a few yards of sterling.”
The Bottom Line
Forex can be a lucrative, but unpredictable, trading strategy for both novice and seasoned investors. Although access to the market — through a broker, for example — is simpler than ever before, the answers to the six questions set out above will serve as a valuable guide for those who delve into FX trading.