Although forex (FX) is the largest financial market in the world, it is relatively uncharted territory for retail traders. Until the popularization of internet trading, FX was primarily the domain of large financial institutions, multinational corporations, and hedge funds. However, times have changed and individual traders are now hungry for forex information.
Whether you are new to FX or just need a refresher course in currency trading basics, here are the answers to some of the most frequently asked questions regarding the forex market.
Key points to remember
- Currency trading is based on credit agreements, which are nothing more than a metaphorical handshake.
- FX trading is self-regulated because participants must both compete and cooperate.
- There is no bullish rule in FX like there is in stocks. Unlike futures, there are no limits on the size of a trader’s position.
- FX traders usually use a broker who charges a commission fee.
- A pip is a percentage point and is the smallest increment in an FX trade.
Answers to Top 5 Currency Trading Questions
1. How does Forex compare to other markets?
Unlike stocks, futures or options, currency trading does not take place on a regulated stock exchange and is not controlled by any central governing body. There are no clearing houses to guarantee transactions, and there is no arbitration panel to settle disputes. All members trade with each other on the basis of credit agreements. In essence, business in the world’s largest and most liquid marketplace depends only on a metaphorical handshake.
At first glance, this ad hoc arrangement is baffling for investors accustomed to structured exchanges such as the New York Stock Exchange (NYSE) or the Chicago Mercantile Exchange (CME). However, this arrangement works in practice. Self-regulation provides effective control in the market as FX participants must both compete and cooperate.
In addition, reputable retail FX dealers in the United States become members of the National Futures Association (NFA), and in doing so, FX dealers agree to binding arbitration in the event of a dispute. Therefore, it is essential that any retail client who is considering trading currencies only does so through an NFA member firm.
The forex market is different from other markets in other unique ways. Traders who think the EUR / USD could take a ride down can sell the pair at will. There is no bullish rule in FX like there is in stocks. There are also no limits on the size of your position (as there are in futures contracts). So, in theory, a trader could sell $ 100 billion worth of currency if he has sufficient capital.
In another context, a trader is free to act on information in a way that would be considered insider trading in traditional markets. For example, a trader learns from a client who knows the Governor of the Bank of Japan (BOJ) that the BOJ is considering raising rates at their next meeting; the trader is free to buy as many yen as he can. There is no insider trading on FX – European economic data, such as German employment figures, is often leaked days before its official release.
Before you leave the impression that FX is the Wild West of finance, note that it is the most liquid and fluid market in the world. It trades 24 hours a day, Sunday 5 p.m. EST through Friday 4 p.m. EST, and there are rarely price gaps. Its size and scope (from Asia to Europe to North America) make the currency market the most accessible in the world.
The forex market is a 24 hour market producing substantial data that can be used to assess future price movements. It is the perfect market for traders who use technical tools.
2. What is the Forex commission?
Investors who trade stocks, futures, or options usually use a broker who acts as an agent in the transaction. The broker transmits the order to an exchange and attempts to execute it according to the client’s instructions. The broker receives a commission when the client buys and sells the tradable instrument to provide this service.
The forex market has no commissions. Unlike the stock markets, the FX is a market reserved for the principal ones. Foreign exchange firms are brokers, not brokers. Unlike brokers, brokers take on market risk by serving as the counterparty to the investor’s transaction. They don’t charge a commission; instead, they earn their money from the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell on the bid as is the case in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every penny earned is pure profit for the investor. However, the fact that traders still have to overcome the bid / ask spread makes scalping much more difficult on FX.
3. What is a glitch?
Pip stands for point percentage and is the smallest increment in FX trading. On the foreign exchange market, prices are quoted to the fourth decimal place. For example, if a bar of soap in the drugstore was priced at $ 1.20, in the forex market the same bar of soap would be priced at 1.2000. The change of this fourth decimal point is called 1 pip and is usually equal to 1/100e from 1%.
Among the major currencies, the only exception to this rule is the Japanese yen. One dollar is worth about 100 Japanese yen; thus, in the USD / JPY pair, the quotation is only raised to two decimal places (i.e. to 1/100e yen, compared to 1/1000e with other major currencies).
4. What are you really negotiating?
FX traders hope to profit from exchange rate changes between currency pairs. For dollar denominated accounts, all profit or loss is calculated in dollars and recorded as such in the merchant’s account.
The foreign exchange market exists to facilitate the exchange of one currency for another, a facility used by multinational corporations that need to continually exchange currencies (i.e. for payroll, payment for goods and foreign supplier services and mergers and acquisitions). Financial institutions use the forex markets to hedge their positions and take directional bets on currency pairs based on fundamental research and technical analysis. Individual traders can also trade currencies to speculate on exchange rate fluctuations.
Since currencies always trade in pairs, when a trader makes a trade, that trader is always long on one currency and short on the other. For example, if a trader sold a standard lot (equivalent to 100,000 units) of EUR / USD, he would have traded euros for dollars and would now be short in euros and long in dollars.
To better understand this dynamic, a person who buys a computer at an electronics store for $ 1,000 exchanges dollars for a computer. This person is short of $ 1,000 and long for a computer. The store would be $ 1,000 long, but now has a computer short in its inventory. The same principle applies to the foreign exchange market, except that no physical exchange takes place. If all transactions are only computer entries, the consequences are no less real.
5. What currencies are traded on Forex?
Although some retail traders trade exotic currencies such as the Thai baht or the Czech crown, the majority of traders trade the seven most liquid currency pairs in the world, which are the four ‘majors’:
- EUR / USD (euro / dollar)
- USD / JPY (dollar / Japanese yen)
- GBP / USD (British pound / dollar)
- USD / CHF (dollar / Swiss franc).
The three commodity pairs are also traded:
- AUD / USD (Australian dollar / dollar)
- USD / CAD (dollar / Canadian dollar)
- NZD / USD (New Zealand dollar / dollar)
These seven major currency pairs account for around 80% of all speculative FX trading. Considering the small number of trading instruments (more than 50 pairs and crosses are actively traded), the forex market is much more concentrated than the stock market.
6. What is a currency carry trade?
Carry is the most popular trade in the currency market, practiced by both larger hedge funds and smaller retail speculators. The carry trade is based on the fact that every currency in the world has an associated interest. These short-term interest rates are set 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 “wearing” is simple. The trader takes a long position in the currency with a high interest rate and finances this purchase with a currency that has a low interest rate. For example, in 2005 one of the best pairs was the NZD / JPY cross. New Zealand’s economy, boosted by huge demand for commodities from China and a hot real estate market, saw rates climb to 7.25% and stay there while Japanese rates remained at 0%. A long trader on the NZD / JPY could have reaped 725 basis points of return on his own. On a 10: 1 leverage basis, the NZD / JPY carry trade could have produced a 72.5% annual return on interest rate differentials without any contribution from capital appreciation. This example illustrates why the carry trade is so popular.
Before rushing to chase the next high-yielding pair, however, be aware that when the carry trade is unwound, the declines can be quick and severe. This process is known as the liquidation of the currency carry trade and occurs when the majority of speculators decide that the carry trade may not have future potential.
For every trader looking to exit their position immediately, the offers disappear and the profits from interest rate differentials are not enough to offset the capital losses. Anticipation is the key to success: The best time to position the carry is early in the rate tightening cycle, allowing the trader to go with the flow as interest rate differentials increase.
Other Forex lingo
Every discipline has its jargon, and the currency market is no different. Here are some terms a seasoned currency trader should know:
- Cable, sterling, pound: nicknames for GBP
- Green note, dollar: nicknames for the US dollar
- Swiss : Swiss franc nickname
- Aussie: Australian dollar nickname
- Kiwi: New Zealand dollar nickname
- Loonie, the little dollar: nicknames for the canadian dollar
- Figure: FX term connoting a round number such as 1.2000
- Court: a billion units, as in “I sold a few yards of pounds.”
The bottom line
Forex can be a profitable, yet volatile, trading strategy for inexperienced and experienced investors. While accessing the market – through a broker, for example – is easier than ever, the answers to the six questions above will serve as a valuable introduction for those new to currency trading.